The Equity vs. Royalty Dilemma in University Technology Transfer

We develop a model, based on asymmetric information, which provides a rational explanation for the persistent use of royalties alongside equity in university technology transfer. The model shows how royalties, through their value destroying distortions, can act as a screening tool that allows a less informed principal, such as the university’s Technology Transfer Office (TTO), to elicit private information from the more informed spinoffs. The model also generates other findings that are consistent with empirical observations. We show that when more experienced TTOs resort to contracts that include royalties, these are lower than those of less experienced TTOs. We also show that the empirically reported superior performance of equity only contracts is the result of selection bias; equity only contracts are designed for the higher value spinoffs. Finally, we use our modeling framework to assess the merits of a contract with variable royalties, sometimes used in practice. We show that such a contract is superior to contracts with non-variable royalties as it can act as a screening tool over a wider range of model parameters while causing fewer distortions.