The VC distribution system is broken

January 13, 2011: 12:50 PM ET

Three weeks ago, shares of Tesla Motors (TSLA) dropped more than 21% in a two-day period. Not because of any product recall or poor earnings report, but because short-sellers realized that a "lock-up period" was about to expire, allowing company insiders to sell shares they had been required to hold for 180 days following Tesla's initial public offering.

The shorts were right.

At least two of Tesla's early venture capital backers chose to distribute shares to their limited partners, once the lock-up had expired. Those LPs, in turn, were required to pay the VCs a percentage of the profits (the technical term is "carried interest," and it's usually 20% of the profit).

The problem, however, is that the carry was marked at a price higher than any of the LPs have been able to sell the stock. And it's perfectly legal. More

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