In the venture capital world, there is a cliche that “lemons ripen quickly” or “lemons ripen early”. And you may hear talk of the J curve.
How are the two related?
What do they mean?
In this sense, “lemon” means an investment that does not work because the company goes out of business. We contrast lemons with “plums”. Plums are those investments in companies that produce a strong return. Because building a successful business takes time, VC exits can take 8+ years. In eight years, the lemons have gone out of business. And you may be waiting still for the return on the companies that are performing. So, the lemons ripen quickly.
As companies have been staying private longer, this phenomenon is even more pronounced.
Now let’s zoom out from the individual startup to thinking about the VC’s portfolio.
Many VCs see a “J curve” in their fund valuation. This means, if we plotted a firm’s total value (y axis) over time (x axis), we would see a “J-shaped” line as value decreases before (hopefully) going up.
Why do firms see growth in this trajectory? First, total portfolio value goes down as the fund spends money on front-loaded organizational and management expenses. Next, the fund may see some losses as startups go out of business. Then over time the portfolio may increase in value as markups and sales boosts valuation. But it may take years before an initial investment in a startup sees any return.
Many successful portfolios see this “J-curve” in their growth. It is also true that many losing portfolios see value that continues to fall over years. An initial decrease in a fund’s portfolio value is neither a sign of failure nor a sign of success.
The depth of the “J-shape” collapse downward varies between VC funds. Some funds have a robust pace of markups from follow-on funding by other investors. The presence of any bias in favor of markups instead of markdowns may reduce the scope of the “J-curve” effect.
By Miles Lasater with Julian Jacobs