Academics have long played active roles in industry, mostly in the fields of engineering and, to a lesser extent, chemistry. In the past 30 years, academics in other fields—notably biology and medicine—have become engaged in commercial activities, serving as consultants to companies and founding their own companies. Such activities offer academic scientists great opportunities to apply their expertise to real-world challenges, impacting human health more directly, learning how business works, and even improving their financial situations. When faculty members found start-up biotechnology companies, the opportunity for enrichment—in both senses of the word—is particularly pronounced.
One of us—Edward Klees—served for more than 13 years as a member of a legal team that reviewed faculty-consulting agreements for the Howard Hughes Medical Institute. The other—academic scientist (and Nobel laureate) H. Robert Horvitz—has been involved in commercial enterprises for more than 25 years. We have both observed that a professor’s approach to a business relationship is often quite different from the approach of professionals whose roots are in the corporate world. For example, we have seen academics inexperienced in business fail to recognize the possible consequences of the legally binding terms of a consulting agreement. We have observed professors starting companies fail to understand the need to carefully examine the complex legal agreements they enter as they commence this new experience. Indeed, we know some academics who do not even read the contracts they sign, and others who read them but go ahead and sign them without addressing errors, omissions, and other concerns. Both kinds of relationships with the commercial sector—consulting and starting companies—require careful attention to legal matters. This article will focus primarily on consulting agreements.
There are very good reasons to do your homework before signing a consulting agreement. Consider the following issues and scenarios related to shares or options in a start-up company:
• Some consultants have lost a great deal of money by paying more in taxes on exercised stock options than they receive later when they sell their stock. Others have paid taxes far in excess of what they would have owed had they filed a Section 83(b) election form with the Internal Revenue Service. Such losses are avoidable with proper knowledge and planning.
• A consultant receives a large number of shares in a company that has not yet gone public. When the company does go public, it makes an offering of shares that includes some held by company directors, officers, and other consultants who had negotiated “registration rights” for their shares. If the consultant had merely asked, she could have gotten the same deal as the company insiders. She did not do so.
• A start-up company merges with another company. All unexercised stock options disappear. If the consultant had asked for “acceleration rights,” he might have been able to convert his stock options into shares before the merger, receiving a fair share of the compensation received by other shareholders as part of the merger. He failed to do so.
Here are some more examples of things that can go wrong, which we offer not because they are likely but because they illustrate the kinds of problems that can ensue when things do go wrong:
• Your contract with GenesRGreat Therapeutics was negotiated with Dr. Smith, the head of the company’s research division. Dr. Smith is fired and you fail to receive the stock options he promised you, so you call Dr. Jones, the company’s new director of research and development. Dr. Jones tells you that they have no record of any stock option grant and there is nothing about the options in your contract. Moreover, the company has fully tapped its stock-option plan and there is nothing that can be done now to address the matter. You had assumed that your contract was fine without explicitly describing the promised options. You were wrong.
Dr. Jones then turns to a new subject and compliments you on your recent discoveries, which you described in a paper in Science. Dr. Jones is especially happy about those discoveries because of the provision in your contract that conveys all your future intellectual property (IP) to the company. His assistant will send you the company’s patent assignment form for your signature, he says, and then suggests you inform your university technology transfer office about the company’s ownership of your IP. Your new discovery is worth millions of dollars, but neither you nor your university will receive a penny.
• You are consulting for a Japanese pharmaceutical company, helping to develop a prototype technology. Your use of the technology in your laboratory has produced promising results, and you have improved the technology. You learn that the company has been acquired by a European firm with a reputation that makes you uncomfortable. Unhappy with this news, you dash off a letter of resignation. The company’s lawyer calls you back to say you cannot resign except for “material cause” and that you have no basis for claiming such cause. Moreover, now that you have purported to quit, he considers you to be in breach of contract and demands that you return the prototype, convey the improvements, and cease any plan to publish research you performed using their technology. You are angry. You tell him that your manuscript has already been accepted for publication and that you will do nothing to stop it. He promises—and the company follows through—to sue you to stop publication. Since your contract allows them to sue you in Japan, the suit is in Tokyo and you will need to find a lawyer there. You must also deal with the journal.
• You consulted for a company, but for various reasons terminated your relationship. Three years later, another company asks you to consult, and you establish this new relationship. A press release is issued. The CEO of the first company then calls to tell you that the noncompete clause you signed makes it illegal for you to consult for any other company until 2 more years have passed.
• You hold 1% of a company’s total stock, and the company is sold for $110 million. You are very much looking forward to receiving a check for $1,100,000—but the check you receive is for only $100,000. You call the company and learn that this is precisely what you are due, because you held common stock while the venture-capital investors invested $50 million with a 2X liquidation preference. That means that the first $100 million is paid to them. Of the remaining $10 million, you receive 1%, namely $100,000. Those same investors receive much of the rest.
How can you avoid problems like these? Read the contract, review your institution’s policies, and ask the company for changes when they are called for. We suggest that before you sign a consulting agreement, you obtain professional legal advice or, at a minimum, advice from a colleague with considerable consulting experience. Few people try to draft their own wills, and many do not even file tax returns without professional assistance. One assumes, of course, that the consulting agreement one signs is a legally binding, enforceable agreement. Whether you hire an expert, the burden is on you to understand what you sign.
As you prepare to sign a consulting agreement, consider the following:
1. Make sure the contract is correct. It is your responsibility to correct mistakes or omissions. It is imperative that the contract is correct on all key terms so that you and the company share the same expectations concerning your commitments and obligations. Misunderstandings benefit no one. Mistakes can make everyone unhappy, and you do not want to start out on the wrong foot.
Do not assume that a company will be upset with you for raising questions or negotiating for better terms. The commercial world is accustomed to discussions and negotiations. Use the consulting agreement as an opportunity to define your future relationship and get things right. You might have to live with what you agree to for a long time to come.
2. Do not violate your institution’s policies. Almost all educational institutions have conflict of interest or conflict of commitment policies that address the issue of consulting for industry. In many cases, they require nothing more than informing the institution of the consulting (or other commercial) relationship. Some policies prohibit faculty members from working as an officer for a company. Others prohibit involving graduate students in or using institutional resources for company projects. There might also be restrictions on the company’s use of your name or your institution’s name, or on quoting you in press releases. The rules can be stricter at public universities or hospitals—especially, in the latter case, if clinical trials are involved. If you receive federal funding, you must also be mindful of the rules of the National Institutes of Health and other funding agencies.
Similarly, you should determine if the company expects you to share confidential studies from your laboratory or results of clinical trials for which you serve as a principal investigator or an adviser to the trial sponsor. Recent headlines (including the indictment last year of a Columbia University scientist charged with disclosing confidential clinical trial results to a hedge fund, in breach of his consulting contract with the trial sponsor) demonstrate the danger of disclosing confidential information to an outside company, especially when the information might be used in connection with illegal insider trading.
In any event, there is no reason for you to sign an agreement that violates your institution’s policies. There is nothing to gain from it, and much to lose.
3. Protect your academic rights. Does the consulting contract assert rights to your future IP, and, if so, is it a reasonable assertion? Almost all companies in the biomedical field claim IP rights in consulting contracts. In general, these rights should be limited to inventions made by you during the course of your consulting work, and your institution probably requires such a limitation in its policies. Licenses for inventions from your academic laboratory should be negotiated separately by your institution. The interest of companies in your IP is understandable and, if terms are reasonable and well-written, perfectly appropriate. A key is to ensure that the company’s IP rights are consistent with your university obligations and it is important to preserve the integrity (and commercial potential) of your academic research.
This issue came up in 2011 before the U.S. Supreme Court. The court let stand a lower court decision that a Stanford University scientist’s assignment of rights in HIV testing technology to Roche Molecular Systems Inc. superseded the scientist’s earlier assignment to Stanford, perhaps costing Stanford—and the scientist—millions of dollars in royalties. Dealing with potential issues like this one is easy: Just add a contractual clause stating that regardless of what is stated in the consulting agreement, the company’s IP rights are subject to the university’s rights to IP as your employer.
Does the contract require you to submit manuscripts to the company for review before you can submit them for publication? Does it grant the company the power to delay or stop publication, or to require co-authorship? In a consulting context, there is generally no reason for publication provisions like these, in contrast with a company-sponsored research program in your laboratory, a situation in which such provisions are expected. A discussion at the start of negotiations should prevent such a problem.
4. Take stock of stock and stock options. Stock and stock options offer the chance to benefit financially from the growth of a company you advise without having to invest very much, if any, of your own money. Companies, especially start-ups or early-stage companies, are often cash poor, so they give consultants stock or stock options (called “equity”) to substitute for cash payments they cannot offer now. Equity and equity option grants also align the consultant's long-term interests with the company’s interests.
However, there is a problem with stock options that is sometimes overlooked, as was demonstrated in one of the above examples of things that can go wrong: When you exercise nonqualified stock options—the type of options ordinarily issued to consultants—federal tax law requires you to pay tax on the difference between the fair market value of the stock and the price you paid to exercise the options. (That is not the case for incentive stock options, but incentive stock options can be issued only to employees.) This requirement is not a problem if you can exercise the option and immediately sell the underlying shares, because then you can use the proceeds to pay the tax. But if you are unable to sell your shares or choose not to do so, you will have to pay tax on the shares you receive after exercise, before you sell them. You will owe taxes on “income” you have not yet received (often called “phantom income”), and if your stock later loses value or the company fails, you will have paid taxes on income you never received. The financial impact can be enormous, and for founders of start-ups, the tax bill can be devastating.
A similar adverse tax situation can arise if the shares you receive vest over time, which they typically do. (Vesting is the process by which restrictions on your ownership lapse with the passage of time or fulfillment of other criteria.) As soon as those shares vest, you owe tax on the difference between what the shares cost you and their present value. Every time some of your shares vest, you owe more taxes, assuming they increased in value since you acquired them. If you do not sell your shares when they vest (and many times you cannot do so, for various reasons), and your shares subsequently lose value, you can end up paying more in taxes than you receive for selling your shares.
There are ways to avoid some of these negative tax consequences. For example, you can submit a tax filing called a Section 83(b) election, which allows you to pay tax at market value when you receive restricted (unvested) shares rather than when they vest. You must take responsibility for this filing, ensuring that it is appropriate to your situation and is done properly and on time. Do not assume that the company cares about your tax concerns. A tax adviser is often helpful concerning this general topic.
5. Make sure you understand the meaning and implications of everything in your agreement. Some consulting agreements include “legalese,” the impact of which might not be obvious. For example, the contract might require you to keep confidential everything the company tells you, even after the contract expires. Does such a statement mean you have to keep it confidential forever? Is such a lengthy obligation appropriate in fields in which innovations have a half-life of a year? How do you know what information you must treat as confidential?
The best approach is to have the contract state what information is confidential. Otherwise, it might be difficult to defend yourself if the company later claims that you have published an idea that they say you learned from them. Even if the claim is untrue, how would you disprove it? Must you keep copious notes of everything they tell or show you? Would that even suffice if you cannot prove you wrote those notes contemporaneously?
Consider these other legal issues:
• What is an indemnity, and why does the contract say you will indemnify the company for any breach of contract? Such a clause can cost you money. Can the liability be limited to some reasonable amount, such as 1 year’s consulting fees? You might want to have insurance to protect you in case this issue was to arise; it might even be possible to have the company pay for such insurance.
• What does assignment mean? Can the company transfer your services to another company, or multiple companies, without your consent?
• What do your covenants to the company mean, and are they fair? A common covenant (promise) in biomedical consulting agreements is a statement from the consultant that none of the IP he or she generates for the company in the course of his or her consulting services will infringe on third-party patents. Is it reasonable to require an academic scientist to legally guarantee such a thing? Does a professor have the skills to function as a patent agent and search the records of the U.S. Patent and Trademark Office to confirm that the relevant IP is not afoul of some existing patent? The company’s patent experts can perform such checking faster and with more expertise than a scientific consultant. Would it not be reasonable to delete the covenant? In any event, it seems highly unwise to make any assurance beyond what the consultant actually knows at that moment. In other words, if the consultant knows nothing about the topic, the contract might state only that the consultant is aware of no claims or patent rights on the technology, that she makes no promise or assurance that there are no patent claims, and that she will not be liable to the company if it turns out that there are.
In the end, our advice is old-fashioned, obvious, but often ignored: You should not sign any contract without understanding what you are signing and getting answers to all of your questions. You should seek the help of a professional adviser, especially if you are considering consulting for the first time or if there are significant, atypical financial or legal issues involved in a particular agreement. Whatever your experience, you should know what you are signing and its potential impact on your life before the pen is in your hand.
Edward Klees and H. Robert Horvitz are the authors of Biomedical Consulting Agreements: A Guide for Academics, just published by The MIT Press and available at Amazon.com, Barnesandnoble.com, and elsewhere. This book considers in greater depth the topics mentioned above as well as other issues involving consulting agreements and includes specific examples of contractual clauses and terms.
Klees is general counsel of the University of Virginia Investment Management Company and a lecturer at the University of Virginia School of Law. Horvitz is an investigator of the Howard Hughes Medical Institute (HHMI) and the David H. Koch Professor of Biology at the Massachusetts Institute of Technology (MIT). From 1995 to 2008, Klees was part of the legal team that reviewed and commented about investigators’ consulting agreements on behalf of HHMI and prepared and interpreted consulting policies on HHMI’s behalf. Horvitz has been a biomedical consultant since 1986, has co-founded five biotechnology companies, and has consulted for 11 biotechnology companies, a major pharmaceutical company, and a venture capital company. He received the Nobel Prize in physiology or medicine in 2002.
The views expressed in this article are those of the authors and do not necessarily reflect the views of the University of Virginia Investment Management Company, the University of Virginia, HHMI, or MIT.