Skin in the Game

To encourage the success of a student start-up focused on higher education issues, the U. of Rochester struck an uncommon deal that would give it an equity stake in the company.
August 2, 2011

Commercial ideas generated at universities are kind of like undergraduates. The university cradles them while they’re on campus, but at some point they’ve got to venture beyond its grounds.

But with so much pressure on universities to be “economic engines” in their states and regions, to churn out job- and wealth-creating businesses that show returns for the area and the university, some academics are arguing that universities need to hang on for the ride. For that reason, many institutions rent space in incubation centers to start-ups to give them the infrastructure to get off the ground.

But the University of Rochester went one step further. Through a deal with an alumnus, the university is planning to take an equity stake in a company created by two M.B.A. students that offers services that might help the university's fund-raisers. Proponents of the move, particularly the dean of the business school and the investor, hope the arrangement will motivate the university to see the company to success.

“Because of that stake, we are working hard to integrate the company’s innovation into our student development and alumni outreach activities,” wrote Mark Zupan, dean of the Simon School of Business at Rochester, in the Rochester Business Journal. “We feel much more like owners with real 'skin in the game' than under the traditional royalty-based approach.”

A university holding an equity stake in a company is not unusual. Many institutions will trade the license to use an idea created with university = resources for a stake in a start-up company. In such situations, universities might also strike royalty deals, sharing in the company's profits. What is unusual about the Rochester deal is that the founders of the company didn't create their product using university resources, so in a legal sense they didn’t owe anything to the institution. The university, through the alumnus, essentially acted as a venture capital firm.

"This wasn’t built in a lab and it doesn’t belong to them in any way," said James Brown, one of the co-founders of the company. "There were strategic alliances for the university being partners with us in this."

While the deal at Rochester has helped the fledgling company grow, others outside the institution worry that such agreements could create conflicts of interest for universities, unnecessarily complicate the venture-capital marketplace, and turn off potential outside investors.

Striking a Deal

Aught9, the company out of Rochester, uses the information that people upload to social networking sites to update university alumni records or other databases. That information can then be used to help with university fund-raising, outreach, or networking. The creators, James Brown and Christopher Sturgill, said they saw a gap in university administration that they could fill and went about devising a solution.

The idea for giving the university an equity stake in the company came about when the co-founders presented to some alumni at a competition focusing on new ideas for the business school. Dan Lazarek, one of the alumni present, thought the company had legs but that it would stand a greater chance of success if the university had a greater incentive to see it succeed. “I just looked at the set of stakeholders that would be needed during an incubator phase, and felt it would have a higher chance of success with the stakeholders having an incentive,” Lazarek said.

Rochester has a long history with the "skin in the game" philosophy -- the idea that managers and stakeholders will work harder and have a better chance at success when they have a personal stake in the long-term health of the company. An equity stake often serves as such a motivator. Zupan traces the philosophy's roots to a 1976 paper written by Michael C. Jensen, a Harvard University professor, and William H. Meckling, a Rochester professor, called "The Theory of the Firm."

Lazarek's point of view was that, because these were students creating a product the university might be able to use, Rochester already had a stake in the company's outcome -- just not an explicit financial one. If the product is successful, then the university and business school will have a story to relay to help attract potential students. It will also have a good product for developing social networks and reaching out to alumni. But Lazarek wanted to add the financial incentive.

So he invested in the company and took an equity stake with the assumption that somewhere down the road, "when the timing is right," he will turn that stake over to the university. The founders and Lazarek said this way they can avoid conflicts of interest, but still provide the incentive for the university to get involved with the company.

And that incentive seems to be paying off. Zupan said he has never worked as hard to facilitate a student venture as he has with Brown and Sturgill. The university became Aught9's first customer, and it is seeing dividends already: through the system, the Simon School has found several alumni it had lost touch with, including some who wanted to make donations to the school or help place graduates in jobs.

The product is currently only being used by Rochester, but Brown and Sturgill are visiting several campuses over the next two weeks to pitch their product to administrators.

Too Much Exposed Skin?

Equity stakes as compensation for the resources and costs associated with patenting technologies are fairly common when universities license ideas generated through their resources to start-ups. In 2009, almost half of all university tech transfer deals included some form of equity, which was actually a decrease from a high of about 70 percent in 2002. Many research universities have had policies allowing for equity stakes in place for decades.

There is also some evidence that equity stakes through the tech-transfer process help spur start-up creation. In a 2003 paper, Dante Di Gregorio, a management professor at the University of New Mexico, and Scott Shane, a management professor at Case Western University, found that universities that had experience taking equity stakes, or a policy allowing them to take equity stakes, registered higher numbers of start-ups than those that did not.

But at the moment, deals like the one struck at Rochester, made outside of the regular tech transfer process, are uncommon. They are even prohibited at some institutions. The Massachusetts Institute of Technology, with one of the highest rates of technology transfer by its faculty and entrepreneurship by its students and alumni, has a policy strictly prohibiting such deals. While the university takes equity stakes in start-up companies that license university technology, the university does not take equity stakes in situations like Rochester's.

Edward Roberts, a professor of technological innovation, entrepreneurship, and strategic management, and chairman of MIT’s entrepreneurship center, said it is not the role of the university to serve as a venture capital firm. Universities don't have the experience or knowledge that traditional venture capital firms do, so they may not be as good at judging what will be successful. “That is not a business activity of MIT,” he said. “We know how to do things we’re supposed to do, and we do them quite well. But that is not one of them.”

Roberts gave several additional reasons for the institution's position against taking equity in start-up companies. Boston has a fairly robust venture capital infrastructure, and there are lots of individuals vying to meet MIT innovators and get in on the ground level of start-ups. If the university started playing the role of the venture capitalist, it could scare away other potential investors, which wouldn't be fair to students.

Other barriers exist as well, including the potential for conflicts of interest. Several states have ethics laws that could prohibit public institutions from holding equity stakes in companies.

But Roberts did not deem the idea of universities serving in an investor capacity an entirely bad one. He said that in situations where there is little venture capital infrastructure, a university could step in to fill that role. "I wouldn't be surprised if, upon an objective assessment of the venture capital or angel capital in the Rochester community, one could conclude that the Rochester investing community could use supplementation," Roberts said. "The university has big bucks and it's able to raise special funds, so investing in start-ups might be a great idea."


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