On the Design of University Investment Funds for Deep Tech Commercialization
A synthesis of best practices and lessons learned from a cross-section of Canadian sources of first cheques toward commercialization of academic IP
The single biggest hurdle to realization of economic benefit from Canadian academic research is the valley of death, the funding gap that exists between the point at which research grants dry up and private sector funding can take over. In their position as the source of most of the deep tech IP funnel, universities are uniquely positioned to both bridge the valley of death and to derive benefit from doing so.
In recognition of the unique position of universities with respect to addressing this gap, in recent years there have arisen an increasing number of university-attached sources of funding for commercialization of academic intellectual property. While a few have been operating for long enough to have exits, most are relatively new, and the approach being taken varies widely between universities.
Over the last several months, I have been surveying sources of first cheques into deep tech companies available from across Canada. The goal of this effort was primarily to learn what has and what has not worked, and to synthesize the lessons learned into a document that can be used to guide design and iteration of such funds across the country. I was pleasantly surprised to find that while variation exists in implementation, there is clear consensus as to best practices and consistency in the lessons learned.
Below, I have assembled a source document, which summarizes some of the content of the conversations that led to this article and serves as the beginnings of a map of the Canadian deep tech funding ecosystem. This is not a comprehensive ecosystem map, as many funds are not yet represented and will be added as more information becomes available.
This is a living document. Both the source document and the primary article will be updated from time to time to reflect the addition of new interviews and additional guidance on best practices. Given the relatively short time that some of these funds have been in operation, ongoing information as to their evolution and success rates will be important in ensuring that this information remains relevant and useful.
If you are involved in a relevant fund (defined as any organization that seeks to get the first cash injection above $25,000 into a startup company commercializing IP arising from a Canadian academic institution) that is not represented here, please reach out to schedule an interview.
Interviewer’s note: This is not a comprehensive set of source interviews, as some of the interviewees requested that the specifics not be made public. In these cases, while the information provided is still used to support and draw conclusions, the details will not be shared publicly. Interviewees were given an opportunity to review, edit, and approve the information shared in the source document, and were given the option of whether or not to be named in the article. Interviewees did not have creative input on this synthesis article, and as such, the opinions expressed here do not necessarily reflect those of any of the interviewees or the institutions within which they work.
Last primary article update: 2024-11-05
Last source article update: 2024-11-11
To Dilute or not to Dilute?
Not all the systems in place to support technology commercialization involve dilutive investment. I have written previously about Lab2Market, a highly effective framework that works with the granting agencies, notably Mitacs and NSERC, to secure non-dilutive funding to support research for companies both pre- and post-incorporation. The more recent formation of the National Invention to Innovation (i2I) Network takes a similar approach, focusing on education of faculty members and postdocs on being effective shepherds of commercialization activity, which can include both direct entrepreneurship but also being a conduit for the entrepreneurship of trainees. The importance of these pre-commercialization efforts cannot be overstated: most academics are poorly suited to be entrepreneurs for the simple reason that it is not part of academic training in STEM fields, and preparing people to be entrepreneurs is a key part of driving their long-term success.
Among programs that do provide cash directly to startup companies, it is abundantly clear that taking equity is a requirement for long-term sustainability. Among the handful of funding sources that provide non-dilutive grants, the need for continuous support through philanthropic or university funding was cited as an existential risk, and more than one such fund has already failed and been replaced with an approach based on dilutive funding. Taking equity in exchange for funding provides a means to ensure the possibility of being evergreen through profit reinvestment in the long run, reducing dependence on external donors and budget cycles and priority shifts with the parent university.
A comprehensive, self-sustaining pipeline to enable commercialization of Canadian research involves both non-dilutive funding to push the technology readiness level to the point that it can be spun out, and dilutive support to cross the valley of death thereafter. Universities are uniquely positioned to be the bridge by which this occurs, and the existence of a separate entity that serves to provide that dilutive funding can assist with both sides of that divide. An entity that makes investment such as those contemplated in this article can enable not just direct investment in the startup, but access to grants that require an early-stage commercialization partner and for which a newly created started will not be directly eligible. It is not unreasonable to assume that every dilutive dollar provided can be leveraged up to 3x with non-dilutive funding, through careful program design that plays nice with federal and provincial sources of grants for commercialization activities.
Governance and Legal Structure
In a few cases (notably Waterloo and UBC), universities went through several generations of commercialization approaches, often starting with an internally managed fund that provided non-dilutive funding and moving progressively toward dilutive funding delivered through a more independent entity.
Among fund managers that do make dilutive investments, opinion was nearly unanimous that to be effective, any investment fund must be arm’s-length from the university. The most common approach was to set up either a for-profit fund that operated entirely independently from the university (e.g. Velocity fund in Waterloo) or a not-for-profit, wholly owned subsidiary of the university with its own independent board of directors (much more common across the country). While some funds have a board that includes a representative of the university administration or a board (usually the VPRO or equivalent), this is not always the case. In all cases, board members from the university administration were not directly involved in making investment decisions, instead having at most veto power over those decisions.
Most contributors expressed a strong preference for as much autonomy from the parent university as possible. Based on my findings, this is desirable for all concerned, including the university itself, for many reasons.
For the fund itself, given the relatively high rate of turnover of university central administration and the possibility of associated priority changes, having a separate entity with a fully independent board shields the fund from both political influence and budget cycle issues that might otherwise make operations uncertain. It ensures that the fund can deliver its mandate to drive a local innovation ecosystem, free from any priority changes or political influence from the central administration. It also avoids running into conflicts with profit reinvestment, where a university administration that has changed its priorities might seek to reappropriate profits for uses outside of the mandate of the fund if they have the ability to do so. Finally, I heard more than one story of funds that ultimately failed to launch after attempting to contort the structure of a dilutive investment fund to fit into the framework of institutional policies. By all accounts, university policies and internally managed dilutive funds are fundamentally incompatible and should not be attempted.
For the investors or donors, having a separate entity opens up the possibility of using the fund as the cost-sharing partner for grants that can be used to leverage the investments made, providing additional impact for their capital above and beyond the direct investment that would not be possible were the fund managed internal to the university. Using a not-for-profit entity also opens up the possibility of a charitable tax receipt, discussed in more detail in the section on funding. Finally, having assurance that the university-affiliated fund is not being influenced by the university to make an unsound investment is a core element of building a trust relationship with other investors who later become co-investors. Nothing will drive away a co-investor faster than an indication that the lead on a round is making a decision based on anything other than a sound due diligence process.
For the university, this structure provides a way to avoid conflict between the not-for-profit status of the university and any related internal policies and the fact that the fund will hold equity in startup companies. It also provides some insulation between the VPRO and the investment decisions made by the fund where a conflict of interest might otherwise arise, to ensure that researchers cannot distort investment decisions by applying internal pressure on their administration in an attempt to change a negative decision to invest. Finally, an independent entity is a key part of a risk mitigation strategy. Universities are extremely risk-averse, and most will not consider taking on a fiduciary duty to any external entity. Keeping management of any funds at arm’s length, especially in a for-profit model like Velocity fund, is necessary but not sufficient to ensure that the University itself holds no liability for the outcome of the fund.
For startups, a dedicated investment fund is preferable on the cap table to a university, which can sometimes be negatively viewed by other investors. It also allows these funds, in cases where they are empowered to lead investment rounds, to be the impetus for getting early-stage investors into a deal that might otherwise not find a lead investor in Canada, given the generally low risk appetite of Canadian venture capital. Funds like Ontario Centers of Innovation, which are investors in early-stage biotech but which cannot lead rounds, are key partners in this endeavor.
Investment Decisions
For dilutive investments, funds surveyed can be loosely divided into two classes based on how the investment team gets paid: funds that pay the investment team directly, and funds that are managed by volunteers or university employees who undertake the work on an “extracurricular” basis. In both cases, given the breadth of technologies typically being considered, this primary investment team is supported by an ad-hoc network of experts from the local ecosystem, including researchers at the parent university, that can be called on to do technical due diligence.
In no cases that I surveyed were decisions on dilutive investments being made by university representatives on behalf of the university itself. This is important from a liability and risk management perspective, and critical to ensure that university faculty cannot exert pressure on investment decision teams or any part of the central administration to distort incentives away from anything other than making investment decisions based on sound due diligence.
The level of due diligence undertaken varies considerably between different funds. Some are mainly concerned with verifying that the technology in question is accessible and are happy to make many small bets based on a lightweight process, while others do a deep dive into the technology portfolio and potential market.
Once a track record has been established, these funds can build networks of other investors with whom to coinvest, and it is often this network that leads deep tech startups to filling their first round. The technical due diligence undertaken by university-attached funds, uniquely positioned as they are to provide guidance on the value of technologies, is often a key value-add for further fundraising.
The due diligence reports from Calgary’s UCeed fund, for example, is often cited by other investors as a key input to their decision to invest, and the model of providing the technical due diligence report to the startup as they seek further fundraising is one that should be strongly considered elsewhere in Canada.
Likewise, Velocity fund enjoys a well-earned reputation as a deep tech leader. Their due diligence for the most part ignores traction and market assessments, knowing that it is often far too early for such things, and instead bases their due diligence primarily on two key indicators: whether the technology in question is sufficiently groundbreaking that it can be safely assumed a market will exist if technical hurdles can be overcome, and whether the team involved is both capable of tackling those problems and is taking a globally differentiated approach to doing so.
For non-dilutive funds, investment decisions are typically either made based on pitch competitions internal to the university, or by third-party granting agencies entirely outside of university control.
In the former case, it was noted that these competitions are generally a poor basis for due diligence and that the correlation between pitch competition winners and long-term startup success is very weak. Most universities that started with this model moved away from it quickly, though there are still a handful that provide small amounts of non-dilutive funding on the basis of pitch competitions.
In the latter case, the value add of having a fund involved in the grant process is significant. In many cases, the fund can pre-negotiate favorable application processing with grant agencies, such that the output of activities supported by the fund are accepted as inputs to the grant application process itself. Examples of this include Lab2Market’s expedited path to Mitacs and NSERC funding.
Cheque Size and Dealterms
Given the general lack of VC funds that invest in deep tech, much of the utility of a university-attached fund lies in their ability to incentivize that participation. While not a hard requirement, the ability to lead investment rounds is a significant value-add to the local ecosystem.
Numbers from recent years suggest that a deep tech company needs about $1M pre-seed to get the ball rolling. Assuming that grants can be used to double any dilutive investment, this means that startups will need to raise about $500k on average, though the distribution is fairly wide. Assuming a lead must supply half the round, this puts a lower bound of $250k on the cheque size that is needed to enable a fund to lead a round. Most university attached funds interviewed are operating in the range of $100k-$250k, and not all of them lead. This is not to say that smaller cheques are not worth writing, but significantly greater impact can be achieved if university-attached funds lead rounds, as this will directly incentivize participation by other investors.
Investment vehicles and terms vary widely. Carta’s numbers suggest that across North America, post-money SAFEs are used almost exclusively for investments in this range. The two largest Canadian university attached funds, Velocity and UCeed, use SAFEs for some of their initial investments, but not all, with convertible notes and priced rounds filling out the rest of the deals.
Given that it usually ranges from very difficult to actually impossible to accurately value deep tech startups while they are still in the research phase, it makes perfect sense to use convertible instruments over priced round for first cheques in to pre-seed companies, and my research strongly supports the post-money SAFE as the default vehicle to use unless there is a context-specific reason to do otherwise.
Funding, Profits, and Timelines
Among the funds reviewed, only one (Velocity in Waterloo) is a true VC fund that takes money from limited partners (LPs), charges a management fee, and distributes profits to LPs. This works primarily because Velocity is not formally attached to the University, instead having evolved into an entirely separate VC fund that simply sources a large portion of its deal flow from the University of Waterloo.
Funds that are wholly owned subsidiaries of universities or are managed internally are for the most part funded by a combination of direct cash from the university and philanthropy from the local ecosystem. In cases where both direct university funding and philanthropy are used, direct funding was used for both operational expenses and investments, while donor funds are almost always used exclusively for investments.
In the philanthropic model, donors provide funding without any expectation of return, instead providing a charitable contribution to seeding the local ecosystem and receiving an immediate tax credit. The ability to attract philanthropic funding is heavily tied to these tax incentives. British Columbia, uniquely in Canada, has a small business investment tax credit that can stack with charitable tax credits, with careful legal design of related funds. In aggregate, it is possible to get $0.82 of refundable tax credit for $1 contributed. This tax credit has been a direct driver of strong donor engagement there and is a model that should be strongly considered across the country. In these cases, donors have no expectation of returns. In some cases, however, donors are directly involved as part of ad-hoc investment committees as an additional benefit to donating. Care should be taken to ensure that this is only the case when donor expertise is relevant.
In all the donor-funded cases that take equity, profits are reinvested back into the fund on a rolling basis, with the explicit intention of becoming evergreen so as to avoid long-term reliance on donations, though engagement with donors on a rolling basis is standard practice in most cases.
The choice of whether to use a standard VC model that takes operational expenses as a percentage of AUM and distributes profits to LPs (e.g. Velocity) versus a fund that uses donor money for investment (e.g. UCeed, UBC) has deep implications.
While the 2/20 VC model is well tested and understood, such funds are necessarily time-limited (usually to 10 years) due to the need to have a clearly defined point in time at which profits can be calculated and distributed and must raise their full allocation of funding up front. Ongoing funding support requires constant raising of new, separate funds that overlap their operational lifecycle, or having spikes in operations where investments are usually made toward the first half of the lifecycle. Funds are also limited to a minimum size due to the need to operate on 2% of AUM, which practically puts a floor of about $10M on the size of a viable VC fund, with many small American funds claiming a practical floor of $30M. It is also the case that deep tech timelines, often measured in decades, are not always suited to a 10-year funding cycle. If a traditional VC model is used, tolerance to long timelines prior to liquidity is a critical element, and Waterloo’s tech ecosystem proves the value of that tolerance.
In a donor-funded model that seeks evergreen status and does not ever redistribute profits, these time-related restrictions are lifted. Without a requirement for a clearly timed set of liquidity events or a need to satisfy LP liquidity timelines, fundraising can happen on a rolling basis within a single fund, allowing the fund to grow in proportion to the willingness of the ecosystem to support its efforts, and in the long run being a driver for an increase in that willingness as previously supported companies become donors. Returns from liquidity events can be reinvested on a continuous basis, allowing such a fund to start with just a few million in AUM and to grow organically over time.
In many ways, the flexibility of the timelines in the latter model is well-suited to deep tech investment, allowing for a much longer time horizon on ROI and liquidity and organic growth of the fund and the local ecosystem in the long term. Among Canadian funds that follow this general approach, UCeed is the farthest along toward evergreen status. It is not by accident that Calgary is North America’s fastest growing technology hub.
Scope
There are two central tensions that arise when considering university spinouts that is worth careful consideration.
The first relates to the question of which companies are eligible for investment by a university-affiliated fund. Most universities start by limiting their investments only to companies affiliated with the university in some way: those founded faculty, students, and staff, in some cases even going as far as to limit eligibility to a single faculty. On the other hand, it is often (though not always) the case that deal flow from a single university is relatively low, resulting in a situation where the fund is making investments based on what is available rather than what is worth investing in. This practice also biases opportunities toward first-time founders. At the other end of the spectrum we have Waterloo’s Velocity fund which can invest in any company in Canada, and UCeed in between, which can invest in any company with ties to Alberta.
The debate is an important one: on the one hand, universities have a mandate to support their researchers and tend to favor a smaller scope of fund, while investment that seeks long-term ROI or evergreen status will seek to find the best companies in which to invest regardless of origin.
In practice there is a strong correlation between a wide scope of investment opportunities and long-term performance of the funds, though it is true in Canada that the sample size from which to draw this conclusion is very small. Several Canadian universities are taking a middle ground approach that involves expanding eligibility to include alumni of of the university, which opens up the possibility of investing in second-time founders and provides a means to keep alumni engaged, which is a high-ROI activity for the university generally and will be discussed in the next section in detail.
The resolution of this debate comes about, unsurprisingly, though clearly defining a mission statement for the fund. If the goal is to maximize the rate of spin-out activity from the university, the fund will favor investment in first-time founders coming from the university directly, but may miss out on the higher success rates of serial founders or the broader ecosystem generally (though the fact that they enabled the first-time founders may have long-term impact as those founders go on to create other companies in the future). If the goal is to create an evergreen fund that can drive long-term economic impact directly, a broad scope of eligible investments will be necessary, but will involve passing on a higher proportion of deals coming directly from the parent university.
The second central tension arises when considering the question of who should be founding a company or involved in its leadership. Many funds, notably TandemLaunch and Velocity, prefer that university faculty and even inventors not be a key element of the business leadership of a company in which they invest, preferring to bring in experienced business development acumen as CEO.
There is a sound argument to be made for this view. Professors at universities are generally not willing to quit their job to build a company, and many treat it as a way to get more research grants rather than a separate project. First-time founders have no idea what they are doing as far as business development goes (I speak here from first-hand experience) and are significantly less likely to succeed on their first attempt. On the other hand, most academic paths end up in industry, and there is only one way to find serial founders: first give them a chance to be first time founders.
In recognition of this, and the need to build the foundation of commercialization expertise as a prerequisite to actual commercialization success, the Lab2Market program and the National Invention to Innovation (i2I) Network have both invested heavily in educational programs to given researchers and faculty the skills they need to be effective shepherds of commercialization activity, regardless of whether or not they are involved as founders of the companies that do the actual commercialization.
Return in Investment for the University
In the case of the evergreen funding model contemplated in the article, the direct ROI for the university is less clear. The cost to the university ranges from a few hundred thousand dollars to a few million dollars per year, depending on the size of the fund, but if an evergreen fund only reinvests the profits, why do it at all?
In the small number of cases where the university is an LP in a fund that directly receives a profit share, there is direct ROI. However, based on what I have learned, the majority of the value for universities does not arise from direct profits shares, but from indirect benefits.
A deep tech fund that can be the first cheque into companies commercializing academic IP will operate in the red for 10 years, at a minimum, but it is the seed of an ecosystem that will build around it and pay dividends in the long run.
The knock-on effects of this early support are many-fold. Supporting a researcher in turning their research into a company, even if that company ultimately fails, creates a grateful alumnus who will be more than willing to pay forward any future success they may have in recognition of the support that gave them their start. Universities depend on donations from the community to finance their projects and deliver on their education and research goals, donations which become infinitely easier to solicit from people to whom the university gave first. Previously supported founders, whether or not successful, can go on to be mentors and guides for the next generation, or join new companies as serial founders, increasing the chance of success of the ones that follow and reinforcing the positive feedback loop.
Keep Watching
It is worth explicitly noting that except for Waterloo’s Velocity fund, it is too early in the lifecycle of most of the University-attached pre-seed funds in Canada to be able to assess long-term performance and the ability of funds that follow this rolling investment model to achieve evergreen status. As with all of my policy recommendations, a key element of the ecosystem value of these initiatives will be tracking of outcomes and ensuring that long-term performance of both the funds and the companies they support are captured and publicly reported.
The Waterloo tech ecosystem proves the value of making the initial investment, and Calgary and other universities are working hard to catch up. If this long-term thinking can be embraced by universities across the country and lessons learned can be shared, supported by sound policy decisions relating to commercialization support, the rest of Canada could achieve similar results within a decade.
Whether or not I can name you directly, I would like to extend a heartfelt thanks to everyone who contributed to the research that went into this article. Your willingness to discuss the complexities and challenges of university commercialization projects and the first-hand insights you shared are invaluable in finding ways to address Canada’s challenges with deep tech commercialization.