Big Appetite: Greylock Sends Entrepreneurs a Message with Expanded $1 Billion Fund

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In case you missed it, being a super angel is officially passe. The new hotness is having a late-stage growth cash. Sequoia Capital is doing it. Andreessen Horowitz is doing it. Kleiner Perkins Caufield & Byers is doing it. Accel is doing it. Hell, even Chris Sacca is somehow doing it.

Greylock is the latest to officially join the club, with news today of an expansion to its current fund, bringing the total to $1 billion– almost double its original $575 million size. The firm will be able to invest up to $200 million per deal.

But other than having more cash on hand, not much else at Greylock is changing. The firm has been doing growth deals already, most notably Pandora, which has filed to go public and the recent Groupon mega-deal.

I talked to Greylock’s David Sze for more than an hour about the news yesterday and at least half of that was an argument over whether or not his 2006 investment in Facebook counts. He argues at a near-insane $500 million valuation it was a huge departure for the firm, and made him the laughing stock of Sand Hill Road…until it proved to be one of the savvier bets of the early Web 2.0 era.

That investment in Facebook was certainly a landmark deal for Greylock, cementing its West Coast comeback and landmark deal for the Valley, giving everyone explicit permission to pay outrageous valuations just to get a piece of a hot company. You still hear it referenced in conversations over how someone could justify a given price.

But calling it a late stage deal doesn’t give Sze enough credit for what was really a gutsy venture deal. It wasn’t just a nosebleed valuation that made Facebook a risk back then– the company itself was far from a sure thing. Facebook hadn’t opened beyond colleges and high schools, the newsfeed hadn’t launched and this was even before the lucrative several-hundred-million dollar Microsoft ad deal. Indeed, MySpace was still the social networking company to beat.

That deal was still a venture investment. The recent mega secondary buy of Facebook shares by Elevation, Kleiner Perkins, Andreessen Horowitz and others are closer to trades. It’s no longer a matter if Facebook makes it; it’s not even a matter of whether Facebook will be the biggest company of this era. It’s an issue of how much you have to pay for shares, and how much room there is for a pop at the eventual IPO. These trades still take connections, since the companies are still private and most of them have the right of first refusal on who can buy their shares. But let’s not kid ourselves that these investors are rolling up their sleeves and helping Facebook build its business the way Jim Breyer and Peter Thiel did.

And that’s what’s raising concerns about these mega-growth funds: That VCs aren’t acting like venture investors who help build companies, they’re acting more like hedge funds. There is also historic precedent to be concerned about a rush to seemingly certain late stage payouts: Most firms fled towards these deals in the late 1990s when IPOs were all but certain and many funds were washed out when the market corrected. Industry-wide, firms took a hard stance of returning to that they knew post-2000: Early stage investing. To see funds creep up from $350 million towards $1 billion after so many people said the bubble proved venture capital doesn’t scale should give the industry pause.

My concern: How many of these great late stage deals are possibly left? These $1 billion+ price tags are going to get a lot more risky as this trend continues and deal quality inevitably slips. There’s only one Facebook, and the economics of Zynga and Groupon make them unique mega-bets too. Twitter is nowhere near as certain of a bet, with three CEOs tagging in already in its young life, nowhere near the revenues of those other giants, not a lot of product innovation of late and an increasingly annoying almost MySpace-like spam problem. As a product, Twitter is one of the seminal Web properties ever to be developed. But the other three Web giants are valued in the double digit billions, because of their product and the businesses they’re building. I’m not saying it’s a bad deal, but it represents a shift in the risk late stage investors are taking.

But Twitter at $10 billion looks like a sure thing compared to the latest investment made by DST– the firm who really started this whole wave with its initial Facebook deal in 2009. DST is rumored to be investing as much as $100 million in Spotify at a $1 billion valuation. Spotify: A company in the most volatile sector of the Web who has tried and failed for more than a year to enter the US market. If Twitter is a company being valued on people’s widespread love of its product, Spotify is a company being valued on the promise that people outside of Western Europe will love its product, should it ever be launched to the wide-world. What’s next a $500 million valuation for Instagram?

But while there may be legitimate reasons for concern, the truth is growth-stage frenzy has little in common with 1999. For one thing, what’s driving the demand for these mega-deals is completely different than the dot-com bubble because there are still few IPOs. Indeed, companies like Facebook, Twitter and Zynga are raising all this money precisely because they don’t want to go public yet. Nothing could be less 1999 than that. It also limits the collateral damage on the economy should deal quality dramatically slip because the risk is mostly staying amid insiders, not being passed on to everyday investors hoping for a winning lottery ticket.

Perhaps the most important distinction is that back in the late 1990s, anyone with a venture capital shingle could raise $1 billion, and that’s hardly the case now. Limited partners are clamping down on VCs hard– a correction from the bubble that’s only hitting the slow-moving venture industry now. Today, only the top ten firms can raise this kind of cash– and I’m being generous by saying ten. Sacca’s fund will likely be the exception of an individual-run mega-fund, based on a shrewd positioning of his close relationship with Twitter, not a new trend of angels pivoting into $1 billion fund traders.

Greylock’s approach wisely takes the potential for a decline in the quality of new deals into account. This isn’t a dedicated growth fund, like those raised by Sequoia Capital, Kleiner Perkins and Accel. It’s just the latest vintage to be invested from seed stage deals to Groupon-like mega deals. And Greylock isn’t hiring a specific late stage staff, rather the late-stage activities will be run by Sze, like the Discovery seed fund is run by Reid Hoffman. Any partner can do a seed deal, and any partner can do a late stage deal. Greylock’s thesis is that late stage companies need constant innovation too, and face a lot of the similar challenges of early stage ventures. While the biggest challenge of a seed-stage company these days is recruiting talent, the biggest challenge for large companies is retaining it.

There’s another important distinction: Greylock’s economics are budget-based, not fee-based. Typically VCs charge 2%-3% of a fund to cover office expenses, but instead, Greylock gives LPs a budget for what it needs to run the office. That allows them to sidestep the biggest ethical gripe some people have about these mega-funds: That they’re a clever way for VCs to put large amounts of money to work that don’t require board seats, and more than double their management fees.

The shrewdest pivot to date may be Yuri Milner’s move to early stage with his open offer to fund all Y Combinator grads for generous terms. Because while Millner may have single handedly disrupted the pre-IPO landscape, he’s going to have a hard time getting what good deals are left with almost all of the top VCs now in the late-stage secondary hunt.