The lock-up period is the timeframe during which insider traders, corporate investors, and company employees cannot sell their shares.
Companies can use the lock-up period for several purposes including share price stability, employee retention, fraud prevention, and publicity.
Let us discuss what is the lock-up period, how it works, and what purposes does it serve a company.
What is the Lock-Up Period?
A lock-up period or lock-up days refer to the timeframe where employees, executives, insider traders, and corporate investors are not allowed to sell or buy shares of a company.
Lock-up periods are arranged usually after an initial public offering of a company when it moves from a private to public status.
Lock-up periods usually work for IPOs. However, they can be arranged for hedge funds as well. Both types of lock-ups work similarly and serve similar purposes to hedge fund managers and IPO managers.
How Does the Lock-Up Period Work?
The IPO lock-up period begins on the IPO date. It can range from 30 to 90 days. A hedge fund lock-up period can range from 90 days to one year.
Corporate investors, insiders, and employees of a company cannot sell or redeem shares of a company during this period. Retail investors and traders can trade shares normally though. The lock-up restrictions do not apply to retail investors and traders.
There is no legal obligation for a company going public to announce a lock-up period. It is purely a management decision to declare a lock-up that serves different purposes including share price stability.
Private companies involve investment banks for IPO arrangements. Investment banks usually buy all the shares required to go public initially. Then, these banks put these shares on the stock exchange through the IPO.
The underwriting process involves business valuations, IPO planning, and other important decisions such as lock-up period length.
Companies usually offer their employees stock options as bonuses and rewards. Therefore, employees would want to see a shorter lock-up period whereas investment banks would like to see a prolonged lock-up.
Once the lock-up period expires, all types of investors including corporate investors and employees are allowed to sell or buy stocks.
Lock-up agreements are an important part of IPO arrangements. These are legal agreements signed between the company and its insider traders to oblige the lock-up period.
Like a lock-up, there is no legal obligation to arrange these agreements. However, investment banks often require these agreements to protect their interests.
The purpose of lock-up agreements is to protect the interests of the investment bank and the company. These agreements forbid corporate investors to sell their shares that may flood the market and affect stock price adversely.
Another key factor is to protect the interest of retail investors. Insiders and employees may arrange an artificial hike in stock prices with an IPO. They may quickly sell shares in bulk after the IPO to take advantage of high stock prices with a large number of shares at their disposal.
Lock-Up Period and IPOs
As mentioned above, lock-ups protect retail investors in an IPO. They protect large corporate investors to sell their shares quickly to take unfair advantage of high share prices right after an IPO.
Corporate investors may include venture capitalists and angel investors that invest in private companies before going public. It means they may enjoy higher shareholding due to earlier investments.
Although insider trading laws also prohibit these corporate investors from selling shares at certain events, a lock-up agreement would legally bind them from selling shares for a sensitive period.
Lock-up restrictions do not apply to retail investors.
Lock-Up Period and Hedge Funds
Lock-up periods can affect the liquidity and investment returns of hedge funds as well. Hedge funds usually invest in distressed loans and other debt securities that are illiquid.
Hedge funds may invest in liquid stocks as well. During the lock-up period, they may need extra cash to keep their fund’s liquidity under control.
Also, hedge funds have different investments with different expiration dates. So, hedge funds managers may diversify the investment portfolio with stocks having different lockups to maintain liquidity.
Lockups are arranged for the first IPO usually. Before an IPO, a company goes through the underwriting process that includes issuing the IPO prospectus and lock-up period.
Before an IPO, the SEC imposes a quiet period starting from the date a company applies for the IPO registration until the date registration statement becomes effective.
During this quiet period, the SEC restricts IPO marketing and public discussions about the stock performance, IPO, and other key financial metrics.
The second quiet period starts from the IPO date and lasts for 40 days. During this period, insiders cannot publicly comment on the stock performance and earnings of the company.
Lock-Up Periods and Investors
A sensible strategy for average investors would be to hold off the lock-up period. No one can predict precisely how stock prices move right after an IPO takes place.
Sometimes, share prices soar right on the IPO day, on other occasions, share prices fall significantly. Therefore, retail investors may wish to hold their investments for lock-up periods.
Another factor to consider is that stock prices may get affected once the lock-up period expires. Corporate investors and insiders may wish to sell their stocks if the share prices are high enough.
It means right after an IPO lock-up expires, share prices may fall again due to increased selling of shares.
Therefore, an ideal time for retail investors may be to buy stocks when the lock-up period expires rather than immediately on the IPO date.
Purpose of the Lock-Up Period
The lock-up period serves different purposes for the company and the investment bank.
Avoiding Insider Trading
Insider trading is prohibited by law anyways. The lock-up period and other legal restrictions help a company avoid insider trading.
A key factor for insider traders is to wait until the insider information goes public. They may also need to fulfill other legal requirements to pursue insider trading.
Share Price Stability
Corporate investors and venture capitalists may own large shareholdings in a company than it plans to offer through an IPO. It means these investors can sell their shares right on the IPO date to liquidate their investments.
The lock-up period prohibits the early selling of shares for insider traders. Thus, this period ensures share price stability for the company.
Large investors and syndicates may manipulate the share prices on an IPO date. They can artificially boost the share price before an IPO and liquidate their investments on the IPO date.
The lock-up days may help a company to prevent such fraudulent activities and keep share prices stable after an IPO.
When insiders and company employees retain shares of a company, it signals positive signs to the market generally.
Retail investors may show confidence in a stock that is held by its own employees and venture capitalists. Thus, the lockups help companies create positive publicity as well.
Some companies offer employee stock options to their employees. One way to retain employees is to extend the ESO timeframe. Another way is to use the lock-up periods during which these employees cannot exercise their stock options.
Companies can effectively use lockups to retain employees and motivate them to achieve their performance targets during these periods.
What Happens to Stock Price after the Lock-Up Period?
Investors should carefully analyze a stock’s performance during the lock-up period. Usually, the share prices fall immediately after an IPO.
If the company performs well, the stock price increases gradually after an initial dip on the IPO date. It means investors can observe closely how the stock prices move during the lock-up period.
Generally, if the stock prices increase, insiders would like to trade their shares once the lock-up period expires. It means the supply will increase after the expiration and the share prices would fall due to increased supply.
Conversely, if share prices remain lower, corporate investors would retain their investments. Retail investors usually sell and that brings stock prices upwards again.
Therefore, retail investors should keep an eye on the share price trends during lockups rather than at price movements at expiry.
Advice for Investors with IPO Lock-Up Periods
Corporate investors may want to liquidate their investments after a prolonged wait with their initial investments in a private firm. However, if they wish to sell quickly after an IPO, it might create a negative impression on retail investors.
Therefore, a company may wish to forbid corporate investors and insiders from early selling of stocks after an IPO. Corporate investors may also benefit from it by helping a company achieve higher share prices and profitability through the lock-up period.
For retail investors, the wise choice is to wait until the lock-up period expires. They can utilize this period to analyze the stock performance. They can then decide to buy or sell their investments depending on their analysis of the stock performance after an IPO.