As Union Square Ventures Looks to Third Fund, Speculation on Size Runs Rampant

Last week in New York, everyone was abuzz about one thing: Union Square Venture’s third fund. Multiple sources tell peHUB the New York-based venture firm is in the market, and there’s no end to speculation over the amount of money it plans to raise. Several sources told me they’d heard the fund was going to be twice the size as its second — a $156 million fund that closed in 2008 — with one source pegging the amount at $500 million.

Firm co-founder Fred Wilson is dismissing talk of a large fund. “The rumors of USV raising a large fund are categorically false,” he wrote in an email on Saturday. “We will never raise a large fund. We like the small fund model and are completely and totally committed to it.”

For good measure, Wilson — never one to mince words — added: “Whomever you got that information from is a lousy source and I suggest you stop listening to them.”

If USV were to raise half a billion dollars, it would mark a major shift for the firm. It raised a debut fund of $125 million in 2004 and kept its second fund small by design, despite racking up some impressive exits and a portfolio that includes major Internet companies, such as Twitter and Zynga.

USV’s exits include Tacoda, which sold to AOL in 2007 for a reported $300 million; Feedburner, acquired by Google in 2007 for a reported $100 million; and, sold to Yahoo in 2005 for a reported $30 million.

USV’s first fund “is a hall of famer,” John Borthwick said when I stopped by Betaworks last week. “[USV co-founder] Fred Wilson has made some of the most astute, well-timed, and well-placed investments of anyone over the last five years.” Borthwick added.

USV’s first fund had an IRR of 57.7% as of June 30, according to the Oregon Public Employees Retirement System, a limited partner in the fund. The IRR for USV’s second fund isn’t meaningful because it is so young, according to OPERS.

USV also has stakes in some hot companies besides Twitter and Zynga. For example, when Etsy, a New York-based marketplace for handmade crafts, raised a $20 million round in August, the financing came at a $300 million pre-money valuation. (The 5-year-old company has raised $51.6 million altogether.)

USV portfolio company Boxee is widely considered a strong contender to big companies like Google and Apple. The New York-based startup sells an open-source gadget that connects users’ TVs to the Internet, allowing them to access video, music, and sundry applications. Besides USV, Boxee’s backers include Spark Capital and General Catalyst Partners.

USV and Spark Capital were also the earliest — and until recently — the only investors in the fast-growing blogging platform Tumblr, which last week raised a new and reportedly “very competitive” (and undisclosed) round of financing from Sequoia Capital.

The round apparently was so aggressive that Wilson wrote on Friday that consumer Web investing has grown too heated.

“I  think the competition for ‘hot’ deals is making people crazy and I am seeing many more unnatural acts from investors happening,” Wilson blogged. “If it were just valuations rising quickly, I’d be a bit less concerned. But we are also seeing large deals ($5mm to $15mm) getting done in a few days with little or no due diligence. Investors are showing up at the first meeting with term sheets. I have never seen phases like this end nicely.”

While plenty of investors could get burned by the frenzy, Union Square looks likely to avoid it by sticking to its strategy of betting on winners as early as possible. In January 2008, when social gaming powerhouse Zynga raised its $10 million Series A, Union Square Ventures was there. And when Twitter raised its $5 million Series A in July 2007, one of its first checks came from Union Square.

It’s largely because of the breakaway successes of Zynga and Twitter that USV could easily make the case to investors that it needs more capital. Already, Zynga has raised $519 million over three more rounds; Twitter has raised $160 million and is expected to raise more before eventually going public. It’s hard for a firm with $156 million to keep up its pro rata share when investors are willing to pour so much more into the same deals.