The value of a venture capital fund’s portfolio typically falls below the value of the invested capital before increasing to provide a positive return. For example, if a VC invests 100 dollars, it’s likely that the VC fund will be worth only 80 dollars (according to the accountants) shortly after the investments are made. Eventually, if all goes as planned, the value of the portfolio will increase be 200 dollars (or more), creating a curve sort of shaped like the letter “J”. As a result, this phenomenon is commonly referred to as the J-curve.

This short-term decline in value is created by two factors:

First, historically, accountants have only changed the value of portfolio companies when they take a new investment at a new valuation. While, in theory, the value of a successful portfolio company is constantly increasing, the value was only changed on the books periodically - at the time of a valuation event. Since portfolio companies typically raise additional capital 12-24 months after their first investment, their valuations were not updated frequently. More recently, accounting rules for private companies have changed to encourage VCs to adjust valuations more frequently, commensurate with significant developments for portfolio companies. Even so, accountants and VCs tend to be conservative in their valuations of successful portfolio companies.

Second, companies that don’t succeed have traditionally shutdown relatively quickly. They burn through their cash and are unable to raise more money since they haven’t demonstrated enough progress.

As a result, less successful companies are written down or off quickly before the successful companies are re-valued, creating a distortion that appears to be a loss of money.