The Zombie Startup: Harvesting Venture Capital Lemons

July 8, 2020 | BlogBlog

What with all the portfolio triage going on out there, as venture investors adjust to the new normal (a down market), you can expect a healthy lemon harvest over the next couple of years. “Lemon” being venture-speak for a zombie portfolio company that isn’t going very fast on a seemingly endless journey to nowhere in particular. Nothing like a good cold chill in the venture business does more for the lemon crop, and while we’ll have to wait and see, early signs – layoffs, write-downs and such – suggest the upcoming harvest will be bountiful.

Harvesting lemons – which, as they say in the business, ripen early – is a critical if often neglected art in the venture business. While you might think that VCs mostly regret their investment whiffs, most will tell you it’s not the quick craters that drive them crazy, but the lemons that soak up so much energy and capital for so little return. Lemons that should have been pruned early on but were instead allowed to rot on the vine.

Anticipating my favorite reviewer’s “so what” question re this blog, here’s why I am writing it anyway. First, less experienced investors might find it useful as a sort of “think before you write that next check” reminder about portfolio management practices. Too, entrepreneurs might benefit from a better appreciation of how investors think about portfolio investments that are chugging along without obvious prospects for getting anywhere significant in any foreseeable time frame. Finally, the fact is that while lemon harvesting is primarily an investor’s job, tending a rotten lemon is not a good in entrepreneurial investment either.

The first thing to know about harvesting venture lemons is that the act goes against the typical VC’s grain. VCs, like entrepreneurs, are mostly of the “often wrong, never in doubt” frame of mind. They are unusually susceptible to confirmation bias: tiny bits of evidence supporting their investment decision is usually weighted heavily, while larger chunks of evidence that challenge their investment decision are discounted. Also, as the typical entrepreneur, VCs have larger-than-average egos, and when confronted with what lesser souls might see as clear signs to fold, are prone to double down. Finally, and I’m serious here, most VCs have a soft spot for their entrepreneurs and asphyxiating a still alive and kicking entrepreneur is not a lot of fun.

All of that said, harvesting lemons early, rather than letting them rot on the vine, is one of the more important if less recognized skills of the best VCs. And step one is recognizing early when they’ve got a lemon on their hands.

Let me start, in terms of recognizing lemons, by noting that it has never been one of my strengths. Much of what I’ve learned about recognizing lemons comes from analyzing my own rotten lemons. Most of the rest from watching others variously get it right and wrong, both in terms of lemon recognition and lemon pruning.

Timely lemon recognition starts with remembering what got you into a deal in the first place, and asking yourself whether that analysis is still valid. Most venture investors invest in people first, with markets and technology following along. Which suggests that losing faith in the team is a good place to start in terms of lemon identification. Whatever other metrics of a given deal, if you get to the point where you doubt you’d get behind the team again (in this deal or another), it’s time to start thinking in terms of (i) re-deploying the team, or (ii) harvesting a lemon. Every bet you make on a team should pass the same screen as the first bet you placed on the team – or you should change the team or pass on the bet.

The next place to look for a lemon is in the deal’s place on the market and technology curves (which should be more or less in synch, right?). Presumably, when you made the investment, the deal was a bit in front of or on the crest of those curves. A deal that has fallen behind the market/tech curves has about as much chance of catching back up as a surfer who has fallen behind a wave has of catching up. Meaning it’s time for either (i) pivoting, or (ii) harvesting.

Finally, and particularly for smaller, less networked investors, you can’t let the financial model for the deal get out in front of your own financial and exit models. An otherwise still attractive deal that has moved towards a more capital/time intensive path to exit than its existing investors can realistically get behind is a candidate for either (i) finding a heftier investor/partner to take over the heavier lifting, or (ii) harvesting.

Dealing with a ripening lemon is, or should be, more complicated than simply “seek and destroy.” The ripening process usually takes some time – time during which a watchful investor should see what’s happening while there are still viable options other than pruning. Deals can be revived, but not resurrected: zombies should be killed, not nourished.

Investors often wait too long, though. Some because they don’t see it, and some because they don’t want to see it. No investor wants to believe – certainly when the evidence is less than conclusive – that a deal needs a serious rethink the end result of which will likely be either a serious and likely contentious intervention on the team, market/technology or financial/exit model axis, or a contentious and possibly ugly and/or embarrassing shutdown.

And so, there are really three keys to timely lemon pruning. First, recognizing that a deal has started ripening and why; second, being willing to start a likely difficult process of fleshing out the root of the problem and exploring options for addressing it sooner rather than later; and finally, being willing to act decisively on the best option. Which, sad to say, often calls for getting out the pruning shears.

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