Three weeks ago, shares of Tesla Motors
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.
Take the case of investors with Westly Capital, a Menlo Park-based VC firm that invests in emerging clean-tech companies. Westly distributed Tesla shares following the lock-up, and calculated its carry by using a five-day trading average. It worked out to just over $30 per share, even though the stock was trading well below $27 per share at the time of distribution (and has not yet recovered).
In other words, Westly was being paid for profits that didn’t actually exist (and paying capital gains tax rates on those fictional returns, to boot). It’s kind of like paying commission to a real estate agent on the listing price, rather than on the actual sale price.
To be clear, this is anything but an isolated incident. Just a few weeks before the Tesla distribution, New Enterprise Associates’ limited partners got similar treatment on a distribution of Motricity
stock, which fell more than 25% in the days leading up to its lock-up expiration.
Neither Westly nor NEA were willing to comment on their distribution policies. But, if they were, it probably would have gone something like this: “Everybody does it. Sometimes it works out well for our LPs, sometimes it works out badly. Either way, it’s clearly spelled out in our original investor agreements.”
They would be right that most VC firms do it. This comes after decades in which VC funds simply would mark carry at the price on the day of distribution, which led to accusations of price-spotting. The five-day trading average emerged as a fairer solution, but it isn’t working out that way — particularly with short-sellers hammering shares in anticipation of the lock-up expiration.
Instead, VC firms must find a way to better align interests with their investors. One option would be to use a 10-day average, including five days before distribution and five days after (a model used by OVP Venture Partners). Or just use a pure 10-day post-distribution average, which currently is employed by Warburg Pincus (it used to use a 20-day post average, but investors complained that it was too long).
Or maybe it’s just time for VC firms to stop distributing stock altogether.
Between 25% and 33% of all VC distributions come in the form of stock, but all of the LPs I spoke with said they would prefer cash (save for instances where the VC fund may still have a board seat with the public company). Not only because it perfectly aligns the carried interest — LPs pay carry on the actual sale price — but also because most LPs do not have in-house trading desks that can easily liquidate large blocks of common stock. Instead, they have to pay a third-party to do it, even further lowering their return on investment.
“I pay my VC firms cash,” said one alternative asset manager. “I don’t see why they can’t give me cash back in return.”