Today I’m introducing a new startup fundraising tool I’m calling the Future Security option, or FUSE for short. A FUSE is a purchased instrument that provides an investor the option, but not the obligation to invest in a startup’s security—any form of security— at predefined terms on or before a specific date in the future. It is a complement to other fundraising vehicles such as equity, debt, SAFEs, and STOs.
Does the startup world really need another financing tool?
I’ve been investing in my own and other entrepreneur’s companies for 18 years as an angel and then later as a VC. The changing startup funding landscape has brought with it changes in attitudes toward funding mechanisms. For example, convertible debt is more accepted today than 15 years ago. We’ve also seen the creation of funding instruments such as Security Token Offerings (STOs) and Paul Graham / Y Combinator’s SAFE – probably the best attempt at blending the best attributes of equity and convertible notes into a functional alternative to both. However, entrepreneurs and investors alike still face recurring challenges that make the fundraising process less efficient and effective than it could be. My hope is that a FUSE will be the best solution to some of those challenges (but certainly not all).
What is a FUSE?
A FUSE is a purchased instrument that provides an investor the option, but not the obligation to invest in a startup’s security—any form of security—at predefined terms on or before a specific date in the future. A FUSE is essentially a call option, in that the purchase of a FUSE by an investor provides immediate cash in exchange for the right to invest (call option) at predefined terms (strike price) within a predefined time period (expiration date). A FUSE provides its buyer time to let the underlying opportunity de-risk itself and ideally appreciate beyond the predefined valuation while offering the seller immediate cash and a higher probability prospect of a larger investment later. FUSEs are not direct investments themselves, but rather derivatives of an underlying investment, which in this case is a security in a startup.
Consider this fictional example of how a FUSE could be used.
Eddie the Entrepreneur is raising a priced seed round for his startup NewCo at a valuation of $5M. Eddie reaches out to Ian the Investor, who is known to invest in companies like NewCo at the seed stage.
After the initial pitch, Ian is interested in NewCo, but there are some short term challenges with getting a deal done. Ian the Investor happens to be devoting most of his time toward working on closing the sale of a portfolio company over the next several months. He also has a trip and two conferences to attend within the same time frame.
Further, Eddie the entrepreneur has shared that a crucial partnership for NewCo will happen within the next 90 days, but Ian is skeptical. Ian believes the asking valuation to be high currently, but if the partnership happens, Ian and Eddie both believes NewCo will very likely be valued and maybe even acquired for more than the current $5M valuation.
That situation in mind, Ian offers to buy a $15,000 FUSE from NewCo to have the right to invest up to $250,000 at the $5M valuation any time within the next six months.
Eddie agrees, Ian wires the funds to NewCo, which then records the transaction as income. NewCo signs the huge partnership 30 days later, Ian exercises his FUSE soon thereafter and wires $250,000 to NewCo, which records that as invested capital.
NewCo sells for $50M a year later and everyone is happy 🙂
Given Ian’s time constraints and reservations related to the key pending development, without the FUSE, he would have passed on the initial investment.
How are FUSEs different from normal stock options or warrants?
- Unlike a FUSE, standard stock options and warrants are not granted in exchange for incoming payment; rather, they are used as an alternative to outgoing payment for services to employees, advisers, and sometimes as a bonus to an investors.
- Most standard options and some warrants vest over time, meaning the option holder must continue to play a meaningful role in the startup over the vesting period for the options to vest and be worth much. The FUSE holder has paid for her rights and no further obligation is required.
- Standard stock options and warrants almost never provide operating capital to a company by themselves. Stock options are usually only exercised if/when a transaction happens that results in the options being “in the money.” The goal of a FUSE, on the other hand, is not only to generate cash through the sale of the FUSE itself, but also to be a shepherd of investment later.
- And perhaps most importantly, standard stock options and warrants are only applicable to equity/stock, whereas a FUSE can be used for any security, maximizing flexibility.
What problems could a FUSE solve?
As a party to each of the following issues either as an investor or an entrepreneur, I can testify to the fact that these are normal, not exceptional, scenarios. The FUSE won’t solve all issues, but it is an effective mechanism which could solve some of these issues some of the time while facilitating the often elusive win-win for both investor and entrepreneur.
|Entrepreneurs need funding, but often dilute themselves unnecessarily by raising more than they need at that time.||Entrepreneurs can raise the bare minimum needed and supplement it with FUSEs at a higher valuation.|
|Investors are intrigued by a deal and don’t want to miss out on it, but don’t always have the time to perform diligence on the investment properly before it closes, so they end up passing on good deals due to timing and the risk associated with lack of diligence.||Investors can purchase a FUSE that guarantees them the optional right to invest at mutually acceptable terms sometime in the future.|
|Sometimes investors are interested, but don’t immediately have the capital available to invest. More rare in the case of a VC fund, but less rare in the case of an angel group or super angel putting together a syndicate.||Investors can buy a FUSE to provide them some time to generate interest and assemble the syndicate without the risk of losing the deal.|
|Companies often need a little more time to grow into their valuation, but need immediate funds to keep the lights on while they do.||A FUSE can be sold to prospective investors that provides the company with cash to help it grow in exchange for providing the investor the right to invest at an acceptable future valuation|
|Investors would like to dive deep into a company’s operations and observe entrepreneurs in action, but the entrepreneur must weigh the benefit of possible funding against the drawback of the guaranteed time and energy it takes to provide this sort of access.||Startup can sell a FUSE to investors, which demonstrates that the investors are serious about making an investment and have a more robust claim that they should be provided the access they require to properly diligence a deal.|
|Material events often occur between the time an investor shows high interest and the time closing occurs. The effect of these events often change the terms of the fundraise.||Buying a FUSE at the time of high interest can provide time for non-obvious issues to emerge and for events to unfold that could positively or negatively affect a company.|
|Investors want exposure in a company when it reaches later stages, but access to later stage opportunities are difficult without earlier investor pro rata rights.||A FUSE with a longer time horizon and higher strike price (valuation) can be sold to prospective investors to generate short term income while offering investors later stage exposure. It’s important that the FUSE holder receive information rights in this case.|
Summary of Investor Advantages
- Guarantees a securitized stake in a company at a pre-determined valuation
- Shows entrepreneurs that investors are serious about investing in a company
- Allows investors a window into the company they wouldn’t have had otherwise
- Buys time for investors to diligence a company
- Buys time to round up syndicate funding for a deal
Summary of Entrepreneur/Company Advantages
- Provides operating cash
- Provides time to grow into or justify a higher valuation
- Increases the attention prospective investors pay to the eventual investment opportunity (“skin in the game”)
- Also improves the odds an investor will eventually invest
- Makes it easier to decide if entrepreneur should allocate time and resources to working with an investor who requests robust diligence information
Unanswered Questions and Concerns
This is a huge experiment. And like most experiments, it’s highly likely to fail. I don’t have this all figured out just yet, but I’m hoping the venture community will help via smart and respectful debate as well as some old fashioned trial-and-error.
I embrace challenges, questions, and criticism. Below are some immediately obvious questions and concerns:
- This type of funding could somewhat reduce the need for traditional venture capital. What is the scale of the impact this could have?
- How many FUSEs representing what amounts can an entrepreneur sell before running into funding round allocation challenges?
- How do we prevent situations in which entrepreneurs do not want FUSE holders to exercise their FUSE options, which could result in misinformation or information holdback?
- Related, what information rights should FUSE holders be entitled to?
- What PNL implications might this have on a traditional fund? Will LPs agree that a FUSE is an expense the fund should cover?
- What are the tax consequences for both buyers and sellers of FUSEs?
- Could one create an entire fund of FUSEs and then transfer or sell pro rata rights to others later?
- And finally, how the hell should a FUSE be priced?
For investors, the optionality of choosing to make a future investment is the primary value of a FUSE. For entrepreneurs, the value of a FUSE is in its short-term cash above and beyond a future investment as well as increasing the probability an investor eventually invests.
While significant and numerous questions remain unanswered, I believe that the venture community is capable of answering them collectively so I am confident that there’s no better time than the present to launch the FUSE.
This will require some cultivation in order for it to have the most impact. Please help if you can.
- If you share this on social media, please make sure to tag me so I can be a part oft he conversation. On LinkedIn please tag David Wieland and Motivate Ventures and Twitter tag @davidjwieland @motivatevc.
- Please sign up below to learn more and become part of the FUSE ecosystem. In order to create critical mass, I’m personally aggregating demand for now. Hopefully someday this won’t be necessary and the inertia of the FUSE will be enough for it to exist on its own. But for now, I’m willing to do the work to connect buyers and sellers. Those who join the mailing list (below) will also be sent a draft of FUSE v1.0 that they can use.
- Please understand that while I believe this new product could create more efficiency and effectiveness in venture funding, as well as stir some really interesting and creative conversations, I frankly have no idea if the FUSE will work as intended. It might just be a terrible idea with horrible consequences. I hope you won’t beat me up too badly 🙂 After all, we ask our entrepreneurs to think big and boldly and to use their unique experience and worldview to inform and inspire creative solutions to problems they intimately face. This is simply my humble attempt at doing the same.
Thank you to my Motivate partner and co-founder Lauren DeLuca, Motivate associates Courtney Trunk and Jackson Bubala, former Motivate associate and now Michael Best attorney Trey Calver, Emily Underwood and the University of Chicago Innovation Law Clinic, and Pete Tarsney, for helping me think through this and build FUSE v1.0.