Doing Business with Faculty Owned Companies

Stetson University College of Law

21st Annual Conference on Law and Higher Education

February 10 - 12, 2000

DOING BUSINESS WITH FACULTY OWNED COMPANIES:

POLICY CONSIDERATIONS

John J. Biancamano

Associate General Counsel

The Ohio State University

33 West 11th Avenue, Suite 209

Columbus, Ohio 43201

(614) 292-0611

A. Introduction

Many colleges and universities are currently entering into business relationships with private commercial entities that would have been unheard of in the recent past. This change in attitude has been motivated in large part by declining revenues and increased costs, which have forced institutions to seek new ways of generating revenue. The higher education community has also recognized that these partnerships can benefit society and the economy by making products of university research more readily available to the business community.

In line with this institutional trend, many individual faculty are looking for opportunities to supplement their incomes by engaging in private sector commercial ventures related to their university work. For some, this entrepreneurial spirit is manifested by an increasing interest in private consulting, which has long been permitted, and in fact, encouraged by most colleges and universities. In the past, consulting connoted the occasional speaking engagement or applied research in which the professor assisted a private firm in refining existing technology. Basic research was reserved for the university lab. Today, faculty often enter into long-term consulting relationships in which they assist private firms in creating new inventions and discoveries. They may hold formal positions within the company management structure and sometimes may take ownership positions in these firms.

In recent years, the consulting concept has been expanded to encompass faculty participation in business transactions involving their university employer. That is, the professor seeks to hold a personal financial interest in a company contracting with the university to commercialize his or her research. In a typical case, a researcher who has invented a marketable technology may create a company for the express purpose of marketing the technology, often with financing from private investors. In other situations, the faculty researcher may receive stock or stock options from a pre-existing company in return for consulting services. The company licenses the technology from the university and may seek to sponsor further research in university facilities, with the faculty inventor as principle investigator. The university may receive royalties under the license agreement as well as a grant for the research. Some institutions have elected to accept an equity interest in the faculty company in lieu of royalties or sponsored research funds.

This paper will focus on the policy implications of these transactions. Litigation risks are discussed in the accompanying paper by Stephen J. Hirschfeld, "The Faculty Member as Entrepreneur."

Institutional Policies

The technology transfer agreement with a faculty owned company is a relatively new phenomenon and many institutions are only now developing policies to manage these transactions. One of the more detailed treatments of the subject to date appears in University of Pittsburgh Policy No. 11-02-03.1 This policy allows faculty, staff and students to hold equity in companies that license their technologies provided that these relationships are reviewed and approved by their department chair, their dean and an oversight committee. Other issues addressed include the amount of equity that may be owned, annual financial disclosures and research sponsored by the company. Policies from other institutions that may be instructive include those promulgated by University of Pennsylvania,2 Rutgers,3 Stanford,4 and Michigan State University.5

These policies quite properly devote a great deal of attention to conflict of interest issues and almost no mention is made of the business aspects of the transaction. It may not be desirable to define the business terms in any detail in an inflexible institutional policy. However, an evaluation of the business capability of the faculty member's company is essential to the achievement of the university's technology transfer goals.

B. Evaluating Faculty Owned Companies

Universities typically cite two institutional interests to justify contracts with faculty owned companies. First, it is argued that faculty participation in the technology transfer transaction will facilitate the university's goal of making its inventions available for practical applications in the marketplace. The opportunity to realize a financial gain beyond a university salary operates as an incentive to faculty for the development of inventions with practical applications. In addition, these arrangements recognize the critical role that the faculty inventor plays in the commercialization process. The inventor has the best understanding of the technology and his or her continuing involvement is essential to the development effort. Some firms are unwilling to license university owned technology unless they know that the inventor will be available to assist with the applications research. The faculty inventor's commitment in these efforts is assured if he or she has an interest in the company.

The second institutional interest is the university's need to attract and retain qualified faculty. It is said that if a university does not afford faculty the opportunity to participate in these transactions, they will migrate to other institutions that will let them do so.

These interests are not entirely consistent. Despite the importance of entrepreneurial opportunities to the faculty hiring process, many factors may make a faculty inventor's company the least desirable vehicle for bringing an invention to market. For example, university researchers are often untrained and inexperienced in business matters. If the faculty inventor insists on personally controlling the management of the company, the financial viability of the venture may be compromised. The company may have insufficient experience, facilities or financial resources. Finally, transactions involving the university, its faculty employee and a private company raise difficult issues relating to conflicts of interest and research integrity, and they present a minefield of potential legal disputes.

If these factors result in a major disruption or the failure of the business, the university's interest in commercializing its technology is obviously defeated. An otherwise marketable invention can be tied up for years in legal wrangling. Moreover, if business disputes arise in the course of the transaction, the university's interest in retaining a valuable professor is in jeopardy. If the institution attempts to protect its interests in these situations, it runs the risk of alienating the professor. For example, if the professor's company does not make satisfactory progress in developing the invention, will the university be willing to terminate the license agreement? If it does so, the professor’s interest in the company may be rendered worthless and his future relationship with the university is not likely to be happy, or productive. If the university is somehow able to regain control of the technology and attempts to market it to another firm, the faculty inventor may have an understandable reluctance to work with the new licensee.

A technology transfer agreement with a company in which the faculty inventor has an interest clearly presents risks not seen in similar transactions with other companies. These risks are increased if university administrators and the faculty entrepreneur fail to appreciate the true nature of the proposed affiliation. The parties are accustomed to dealing with each other in an employer-employee relationship complicated by issues such as tenure, academic freedom and faculty governance. The proposed contract between the faculty member's company and the university is something entirely different - a business relationship in which the profit margin is the only indicia of success.

The profitability of university activities usually ranks low on the list of institutional priorities. Faced with a proposal from a faculty-owned company, academic administrators may give inadequate attention to the institution's financial goals and may fail to consider other more desirable technology transfer options. Faculty may approach these transactions with an expectation that they are entitled to the deal and may be offended if the university makes demands or requires performance benchmarks or other assurances.

In order to ensure the success of the venture, the viability of the business should be the first consideration for both parties. The university should perform a rigorous analysis of the business merits of the faculty member's proposal and should make it clear from the outset that it will not contract with the faculty member's company unless it determines that the arrangement presents the best opportunity to develop the technology. In performing this analysis, the following questions should be addressed.

Has the faculty member created a viable business entity?

The faculty company should be required to demonstrate that it has access to capital, operating funds, and other resources sufficient to make the business work. It should also have credible and experienced management.

Does the company have a business plan?

The company should be required to submit a business plan that demonstrates an understanding of the technology and its potential market and that contains a realistic and effective commercialization strategy.

Is the faculty-owned company the best vehicle for developing the technology?

The university should make a thorough evaluation of the invention's economic potential and the pool of potential licensees before it decides on the most advantageous method for developing the technology. In some instances, an established company with prior experience in the area may present a greater probability for success. In this regard, it is important to resist suggestions to commit to the faculty company too early in the research process. Faculty sometimes want to start a business and sign a university contract when the technology is at an early stage of development, before either party understands its full potential. It is not realistic to believe that the faculty company can attract financial backers at this point, and more importantly, it is difficult for the university to determine whether other commercialization options are more appropriate.

Both parties must recognize that it is in nobody's interest for the university to forego an agreement with a promising licensee in favor of an arrangement with a less capable faculty owned company. If the unrelated company succeeds in marketing the technology, the faculty member will at least receive royalties through the university. Obviously, if the faculty member's company fails, everyone loses.

Protecting the Credibility of the Transaction

Finally, a due diligence review of the transaction will help to address the conflict of interest concerns discussed below. Technology transfer arrangements with faculty companies can be criticized as "sweetheart deals" if preferential treatment is given to the faculty inventor, to the detriment of the university. The credibility of the transaction, and that of the faculty participants, will be enhanced if the university performs a thorough evaluation of the proposal and signs a contract that adequately protects institutional interests.

C. Conflicts of Interest

When faculty and administrators focus their attention on the market potential of university research, they should also take steps to ensure that traditional academic values are not compromised. In particular, the parties must be concerned about conflicts of interest that arise when faculty participate in university transactions commercializing their research.

PHS Regulations

Recognizing the entrepreneurial trend in university research, the Public Health Service promulgated regulations effective October 1, 1995 which established standards to ensure that research funded by PHS will not be biased by any conflicting financial interest of the investigators responsible for the research.6 The National Science Foundation issued a policy applicable to NSF funded projects that was substantially similar to the PHS regulations.7

The PHS regulations require institutions to maintain a written and enforced policy on conflicts of interest and to inform each investigator of that policy. The policy must require investigators planning to participate in PHS funded research to disclose significant financial interests (i) that would reasonably appear to be affected by the research, and (ii) in entities whose financial interests would reasonably appear to be affected by the research. The institution must designate an official to solicit and review the financial disclosure statements and the policy must provide guidelines for the designated official to identify conflicting interests and to take appropriate action to ensure that they will be managed, reduced or eliminated.

The conflicts of interest8 that arise when the university contracts with a faculty owned company are readily apparent. In addition to the potential for bias in conducting research, these transactions raise concerns about improper use of university facilities, staff and students.

When asked to file financial disclosure statements mandated by university policy, some faculty may argue that as individuals, their behavior has been and will continue to be above reproach. They may contend that it is unfair to attribute to them the motives of a few bad actors and to subject them to the inconvenience of conflict of interest disclosures and restrictions.

This argument fails to recognize that conflicts of interest are in large part problems of perception. Whether we like it or not, society as a whole, and the press in particular, assume that a personal financial interest is highly likely to influence an individual’s professional judgment. Actual behavior is irrelevant. It is the perception that counts. If the author of a scholarly article evaluating a new drug is found to have an interest in the company that sponsored his or her research, many people will question the credibility of the article.

While this generalization may be inaccurate and unfair when applied to individuals, it is sometimes grounded in fact. On a regular basis, we read reports of scientific misconduct motivated by a desire for pecuniary gain.9 The number of these cases is insignificant in light of the huge volume of research conducted at colleges and universities but they reinforce the common perception. We should also be aware that while most of us would not give in to blatant corruption, a personal financial interest can exert subtle influences on our professional behavior in ways that we may not fully understand.10

Strategies for Managing Conflicts of Interest

Conflicts of interest that arise out of a technology transfer agreement with a faculty owned company can be managed or reduced by putting in place administrative safeguards that limit the entrepreneurial professor’s ability to make self serving decisions and eliminate any appearance of impropriety. These safeguards should be memorialized in a conflicts management plan signed by the faculty members involved as well as the university administrators charged with the responsibility for enforcing it. The document attached as Appendix A is an example of such a plan. An exhaustive discussion of all the conflict of interest issues that may arise is beyond the scope of this paper. Appendix A may contain provisions that some may deem unwise and it is offered only to illustrate some of the questions that should be considered.