INTOSAI Working Group on the Audit of Privatisation

Papers for the Eighth Meeting
Budapest, 11 and 12 June 2001

Commercialisation projects in the United Kingdom and their audit: Note by the UK National Audit Office

Purpose of this note

1. The UK Government is encouraging public bodies to make better use of their assets. This note examines one aspect of that policy, the commercial exploitation of the outputs of publicly funded research in a variety of ways including joint ventures with private sector partners. It identifies key aspects that public bodies have to consider in constructing commercialisation projects, and the approach which the NAO are taking when they examine the value for money of such projects, against the background that auditors are sometimes accused of encouraging risk avoidance rather than well managed risk taking. A notable feature of such commercialisation projects in the UK is that in a joint venture with the private sector the public sector body tends to be the junior partner. This raises issues similar to those encountered in other cases where the state is a minority shareholder in private businesses.

2. The Government have made it clear that their priority for research establishments remains the conduct of publicly funded research in furtherance of public interest objectives. But alongside this objective, the Government are also encouraging the transfer of knowledge through commercialisation projects in order to generate wealth, either directly or indirectly. To this end they are seeking to establish an environment in which all public bodies, to an appropriate level, undertake commercial exploitation of their assets. This is already taking place to an extent. For example, many publicly funded scientific/medical research establishments undertake specific tasks paid for by the private sector, or provide consultancy services. Additionally many of these establishments work internationally. A few, mainly in biological research and defence sectors, have also been exploiting their intellectual property to produce derived goods through what are known as spin-off companies, or joint ventures with the private sector.
3. Various commercialisation routes and structures are available to public bodies, including

1. licensing arrangements (eg database, intellectual property rights)
2. legal partnership (including limited liability partnerships)
3. contractual joint ventures (parties operating as independent contractors rather than as shareholders in a company or as partners in a legal partnership)
4. equity joint venture – limited liability company.

4. An interesting example of commercialisation is provided by the Medical Research Council, a publicly funded body active in the field of bio-medical research. The Council has been engaged in transferring technology to commercial enterprises. It has done this through licensing its intellectual property and establishing laboratories for research collaborations with industrial partners. The over-riding objective Is to select partners judged most likely to develop such technology into medical products and health services useful to society. Among the 17 spin-off companies which have been established, two have become major quoted companies (Celltech Group plc and Cambridge Antibody Technology plc) and most of the remainder have attracted further investment and expanded since their launch. Many of these new company initiatives involved partnerships with other academic institutions and research charities in the U.K. and overseas, many of whom have also contributed technologies to these joint undertaking. These undertaking have also contributed to two of the Council’s subsidiary objectives – wealth creation for the nation and a financial return for the Council, whose income from exploitation of intellectual property was £582,000 in 1990-91, rose to just over one million pounds in 1994-95, and is projected to exceed £17 million in 2000-01.

5. A key aspect of a successful commercialisation project is to know the risks you are taking and to establish responsibilities for those managing the risks. This will involve obtaining relevant timely information, making contingency plans, and being alert for opportunities, because there are upside as well as downside risks. The aim is not to eliminate risk but to maximise the risk: reward ratio across the risk portfolio. This is particularly important where the commercialisation project takes the form of a joint venture or partnership with another party. That will involve allocating particular risks to the party best able to bear them (see draft guidelines on the audit of public/private partnerships and concessions).
6. Well managed risks are those where the staff of the public body engaged in negotiating and operating the project have the necessary skills, or access to those skills, have clear responsibilities and a well thought - through incentive/reward structure. It means having in place business processes, systems and controls. And it means focussing on the desired outcomes of the project. In the case of the commercialisation of research this can involve the management of a portfolio of projects in which there are likely to be failures as well as successes.

7. In 1999 the Government commissioned a report from a leading entrepreneur into realising the economic potential of public sector research establishments (the Baker Report). The report noted fear among some research establishments that they might be criticised by the NAO and Parliament if they invested funds where the outcome was uncertain. The report produced no example of well-judged risk taking being criticised by the NAO and Parliament.
8. The NAO responded to the Baker report stressing their open minded and supportive approach to innovation, plus support for well thought – through risk taking and experimentation. They recognised the potential of this initiative to maximise value for money and to secure additional economic benefits without detracting from public policy objectives. They underlined that intellectual property management and marketing expertise are required, as are commercial partners and appropriate incentives, and announced their intention of examining how the commercialisation initiative was working in practice, with the aim of identifying and promoting good practice so that constructive experience could be shared.
9. Since then it has become clear that public sector bodies in the UK recognise that they have some way to go in identifying and managing risks. The NAO report (August 2000) "Supporting Innovation: Managing Risks in Government Departments" (available on the NAO website www.nao.gov.uk) noted that, in a survey of all government departments, while 57% said they had procedures for reporting risks, only a third said that regular reports were an effective component of managing risks, and two fifths regarded themselves as more risk averse than risk taking.

10. The NAO have embarked on a series of studies of joint ventures and commercialisation projects which will aim to identify good practice. The emerging picture so far is mixed with evidence of some well founded risk taking, with a growing number of opportunities identified and explored. The following paragraphs focus on 4 aspects: legal powers, intellectual property, incentives and portfolio management, and conclude with some pointers from two NAO examinations. It is of course early days as regards the development of commercialisation projects and the lessons which might be drawn. So what follows is subject to revision in the light of experience.

11. In the UK not all public entities have the legal right to own and control a profit seeking venture, or sometimes even to take a minority stake in such a venture. In each case the legal position needs to be checked. Similar constraints may apply to entities that have been organised to enjoy tax free charitable status, although in many cases it will be possible to establish a separate, taxable, trading activity. Where the public body takes a minority stake, it needs to consider how to lay off for the risk that the majority partner will abuse its position. In one example. the public body ceded majority ownership and full management control to its private sector partner, but reduced the risk involved by retaining contractual protections backed up by acceptance by the partner of full access to the records of the joint venture. The legal position on ownership should also be checked for both physical and intellectual property. In the case of commercialising research, the right to use or licence the intellectual property may be conditional on approvals from another public body that originally funded the research. In other cases there may be copyright issues or third party rights.

12. Many public sector entities have a proper inventory of physical assets but do not know what they own in the form of intangible assets, such as intellectual property. Alternatively, they may know that they own such property or a database with potential commercial value, but may not have an up-to-date independent valuation that may well be higher than their own management estimate. The research establishment needs to ascertain what intellectual property it owns, to assess and value the intellectual property inventory and select the property worth protecting and exploiting, to review ownership and control of the property in the light of interest in the commercial potential, and to package and market what is on offer. The INTOSAI guidelines on best practice for the audit of privatisation stress the importance of valuation as a pre-condition for negotiating a good deal. The same is true for valuing the under-utilised assets that the public sector intends to contribute to a commercial venture. And, of course, their value to the venture will be greater than their value as an idle resource.

13. Incentives are needed at the level of the research organisation itself, the team negotiating the deal, and the individual members of the team. These are a vital stimulus to exploitation. Two issues stand out: first, acceptability and propriety, and second the potential for conflict between the public duties of the research establishment and commercial advantage. As regards to the acceptability of incentives, it is the responsibility of the research organisation to decide what it can defend publicly: the NAO support good practice guidance by the Treasury (Ministry of Finance) on incentives and conflicts of interest and, as regards propriety, are ready to give advice to research establishments on what Parliament might regard as acceptable.
14. In developing incentive regimes the public sector body should endeavour to secure

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