Lock-Up Agreement

What Is a Lock-Up Agreement?

A lock-up agreement is a contractual provision preventing insiders of a company from selling their shares for a predefined period of time. They are regularly utilized as part of the initial public offering (IPO) process.

Despite the fact that lock-up agreements are not required under federal law, underwriters will frequently require executives, venture capitalists (VCs), and other company insiders to consent to lock-up arrangements to prevent over the top selling pressure in the initial not many months of trading following an IPO.

How Lock-Up Agreements Work

Lock-up periods normally last 180 days, however now and again can be essentially as brief as 90 days or up to one year. In some cases, all insiders will be "locked out" for a similar period of time. In different cases, the agreement will have a staggered lock-up structure where various classes of insiders are locked out for various periods of time. Albeit federal law doesn't expect companies to utilize lock-up periods, they may by the by be required under states' blue sky laws.

The subtleties of a company's lock-up agreements are constantly unveiled in the prospectus documents for the company being referred to. These can be secured either by reaching the company's investor relations department or by utilizing the Securities and Exchanges Commission's (SEC) Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database.

The purpose of a lock-up agreement is to prevent company insiders from dumping their shares on new investors in the long stretches of time following an IPO. A portion of these insiders might be early investors, for example, VC firms, who bought into the company when it was worth essentially not exactly its IPO value. Subsequently, they might have a strong incentive to sell their shares and realize a gain on their initial investment.

Also, company executives and certain employees might have been given stock options as part of their employment agreements. As on account of VCs, these employees might be enticed to exercise their options and sell their shares, as the company's IPO price would more than likely be far over the exercise price of their options.

Special Considerations

According to a regulatory point of view, lock-up agreements are intended to assist with safeguarding investors. The scenario that the lock-up agreement is intended to stay away from is a group of insiders taking an overvalued company public, then, at that point, dumping it on investors while running away with the proceeds. This was a real issue during several periods of market exuberance in the United States and is the motivation behind why a few blue sky laws actually have lock-ups as a legal requirement.

Even when a lock-up agreement is in place, investors that are not insiders to the company can in any case be impacted once that lock-up agreement runs past its expiration date. At the point when lock-ups lapse, company insiders are permitted to sell their stock. In the event that a significant number of the insiders and VCs are hoping to exit, this can bring about an exceptional drop in the share price due to the tremendous increase in the supply of the stock.

Of course, an investor can take a gander at this in two ways, contingent upon their impression of the quality of the underlying company. The post-lock-up drop, on the off chance that it to be sure happens, can be an opportunity to buy shares at a briefly depressed price. Then again, it tends to be the principal sign that the IPO was overpriced, signaling the beginning of a long-term decline.

Illustration of a Lock-Up Agreement

Studies have shown that the expiration of a lock-up agreement is generally trailed by a period of abnormal returns. Sadly for investors, these abnormal returns are all the more frequently in the negative heading.

Curiously, a portion of these studies found that staggered lock-up agreements can really impact a stock more negatively than those with a single expiration date. This is astonishing, as staggered lock-up agreements are many times seen as a solution to the post-lock-up dip.

Features

• A lock-up agreement briefly prevents company insiders from selling shares following an IPO.
• It is utilized to safeguard investors against extreme selling pressure by insiders.
• Share prices frequently decline following the expiration of a lock-up agreement. Contingent upon the fundamentals of the company, this can introduce an opportunity for new investors to buy in at lower prices.