What did the partners get out of their commitment in addition to their tax write-offs and the $2,153.85 each original investor received earlier? Nine months after the second offering, in June 1981, Compulaser exercised its option to buy back its patent licenses and technology from the second partnership. The payout for each of the 27 units -- whether $50,000 or $100,000 -- was 20,000 restricted shares of Hadron common (which couldn't be sold for two years), plus 20,000 shares of Compulaser common, which had no public market. In early 1982, no investor had yet hit pay dirt. Hadron stock was selling at 2 1/2 bid. The fact that it was down from 5 in six months was academic, since it wasn't tradable until June 1983, in any event. Compulaser had filed for a public offering and issued a preliminary prospectus indicating a $3 selling price.
Thus the best a unit could do -- even if all stock could have been sold in January -- was a payback of $110,000. That's a far cry from the fortunes of the partners in an R&D deal with Metricon, a private Silicon Valley manufacturer of lasers. They put up $750,000 and were bought out by Johnson & Johnson within 18 months for a reported $3.8 million.
Hadron's R&D investors may see greater profits if the stock goes up, thanks to their having kept Hadron in the laser business. "This is not a free lunch," says Laiti, referring to the dilution of his company's stock, "but we couldn't have stayed in the laser market without R&D financing. It gave us the chance to become a growth company without bank loans or in-house R&D financing. To me, that's the crux of government support of R&D through write-offs. It has allowed us to be a viable competitor in a multimillion-dollar market."
Though Hadron expects to post sales of $22 million in its current fiscal year, it hasn't stopped using R&D partnerships. Hadron is going after even bigger money, this time through a public offering. The advantage of the public offering is that Hadron can thus attract more than 35 investors, the limit for smaller private placements. "The disadvantage, though," comments Laiti, "is the amount of time it takes to get the offering okayed by the Securities and Exchange Commission. When we did our private offering, it took three months from the time we wrote up the memorandums to the time we'd sold the units. We've already spent six months on this public offering and we're still not selling."
Hadron's funding saga illuminates one direction that research and development partnerships may take. There are any number of other maneuvers that can be devised by the ingenuity of lawyers and financiers. But all must adhere to the fundamental conditions that define research and development partnerships.
An R&D partnership, ranging from a few people to a few hundred, pools its funds and "hires" a separate company, called the "sponsor," to carry out research and development work on a specified project. Often the sponsor is also the general partner and assumes all obligations of general partners in any partnership; sometimes the general partner is independent of the sponsor. In return for the investment, the partnership owns all the sponsor's output, which usually culminates in a new technology or advanced product. The limited partners have a tax deduction for the dollar amount of the R&D contract. In a separate agreement, the partnership grants the sponsor company an exclusive license enabling the sponsor to market the technology on the partnership's behalf. The sponsor then pays royalties to the partnership out of sales.
At the same time, the partnership grants a purchase option that allows the sponsor to reacquire the technology in its entirety or, alternatively, to walk away from the project. The option can be exercised by paying sufficient royalties to the partnership, by paying straight cash, by supplying stock in the corporation, or through a combination of the three. If the technology fizzles, the sponsor simply lets the purchase option lapse. The partnership swallows the failure lock, stock, and barrel.
But the partnership is not generosity incarnate. Against the risk of being wiped out are weighed potentially big returns if the invention is successfully marketed. A partner stands to make as much as 50% per year, compounded annually, net of capital gains. There aren't that many investments anywhere that will yield as much these days. The partners often can establish long-term capital gains even if the sponsor elects to pay royalties rather than a flat buy-back fee. This, plus up-front tax sheltering, make the risk acceptable to the right (read "rich") investor.
Because royalty rates paid to the partnership are often steep, sponsor companies usually choose to buy back the technology if it's promising. Some deals are now being written in which there is a minimum royalty payment due the partners regardless of sales. This "encourages" the sponsor to market the product aggressively. At the other end is sometimes a maximum aggregate royalty, or cap, beyond which the sponsor is considered to have discharged all obligations to the partnership. If the sponsor decides not to purchase the technology, the partners should then be free to try to market the technology somewhere else.
Many arrangements -- "equity partnerships" -- give the partners a shot at getting equity, rather than cash.Depending on the risks of the project, the number of shares involved will range from around 65% to 100% of the amount a venture capital firm would expect to receive in an ordinary financing. But the partners' total return is enhanced by the tax deductions accorded partnerships through Section 174 of the Internal Revenue Code. The after-tax cost of such shares to the partnership, which can deduct most contributions when made, is at most 50 cents on the dollar. The key to this favorable tax treatment is that the limited partners have a choice in the matter and do not automatically receive stock. Otherwise the Internal Revenue Service may apply its "disguised equity" doctrine to take away the Section 174 deduction.
