When a company is about to go public, early investors anticipate the stock rising after the IPO, but they must also endure a mandatory waiting period called the lock-up period. This period keeps pre-IPO investors from immediately selling their stock. Why does this exist, how does it impact the stock and what are some of the recent dynamics around this period?
What Is an IPO Lock-up Period?
The IPO lock-up period is a pre-set period of time – conventionally 180 days – after a company goes public, during which some early investors and employees of the company are not allowed to sell their shares. These restrictions are not mandated by the Securities and Exchange Commission (SEC), but rather are self-imposed contractually by companies or are required by the investment banks underwriting the IPO. Typically, company insiders own a lot more shares than the public market. Therefore, if large shareholders were allowed to off-load holdings immediately after a company goes public, these selling activities could drastically depress the stock’s price. As such, the purpose of a lock-up period is to ensure that shares owned by company insiders do not all flow out together into the public market too soon after the offering, increasing the supply (float) of the stock with a massive inflow of sellers and thereby negatively impacting the stock price. The “cooling-off” period mandated by the lock-up can also help reduce the volatility of the new stock and allow for the market to settle into a share price based on natural supply and demand and initial company performance. The traditional 180 days also give the company time to announce up to two consecutive earnings reports, which can serve to provide additional details and track record regarding the business operations and outlook.
Lock-up periods can also be a way for companies to keep up appearances. When those closest to the company hold their shares, it can signal to investors that they have confidence in the strength of the company. If company insiders start to sell their stock, investors may get suspicious and be tempted to sell their shares as well. Even if the insiders were trying to cash in their stocks for no other reason than simply wanting the money, public perceptions may change based on the selling activity of insiders. The lock-up period can prevent this from happening—at least while the newly public company gets off its feet.
While lock-ups do exist to protect the stock and the shareholders from an over-supply of shares and the potential downward pressure on the stock that can come with that, they can also create an “overhang” or pressure on the stock due to the expectation of an increased supply and concurrent price pressure. This overhang is why a company’s stock price usually drops leading up to and on the day that the lock-up expires.
Early Lock-up Release
Increasingly, some companies and banks are instituting earlier releases from lock-ups in order to lift the “overhang” and downward pressure on the stock and to relieve the pressure of a straight cliff after the 180-day lock-up. The main goal is to keep shares attractive to new investors by delaying the price pressure that can come with insider sales. At the same time, an early release can reward early investors for taking bets on the company by allowing them to benefit from IPO success and by giving them a “safe window” within which to sell their shares. This decision must also be weighed objectively by all constituents, balancing the fiduciary obligations of the board and the executives with their obligations to their institutions. Additionally, the decision should balance the underwriters’ expertise and market knowledge with the fact that they will receive a fee for the underwriting of a secondary offering, at the likely expense of the company’s share price. Keeping in mind all of these considerations, early lock-up releases can be done in several different ways.
Strategies for Lock-up Releases
Companies may decide to have multiple lock-up periods that end on different dates and allow different groups of people to sell their shares at different times. For example, when one lock-up period ends, company executives might be allowed to sell their shares, while a subsequent lock-up ending means regular employees can sell their shares. While this approach can help in the orderly dissemination of shares, it also is generally done confidentially, and the surprise announcement can have a negative effect on both investors and insiders who are not included in the early release. If the stock price goes down as a result of the first early release, those investors who were excluded and who are still locked up then will be faced with a deflated share price when they are finally released from their remaining lock-up period.
Another option is for companies to specify a particular price target as a condition for early lock-up release. Many believe that performance-related lock-up expiration rules are beneficial for shareholders, as this approach is more transparent and formulaic than the informal and private discussions that can often take place between banks and the company about whether to allow early sales. While the confidential discussions and ultimate “surprise” decisions can upset some investors and insiders who are not included in the early-release, public disclosure of lock-up release parameters do not involve this element of surprise or perceived selling hierarchy.
For example, Snap, the parent company of social media app Snapchat, went public with an IPO on March 2, 2017 and closed at $24.48 after pricing at $17. The company used a system of multiple lock-ups with different expiration dates. The first lock-up expired in July of 2017 and allowed early investors and insiders to sell up to 400 million shares of the company; volume more than quadrupled from the average, and the stock closed at $15.47 on the day of the first expiration after trending down leading up to that date. A second lock-up expired in August of 2017, again with significant volume and the price closing under $12, allowing regular employees to sell their pre-IPO shares in the company. When this lock-up ended, employees were allowed to sell more than 780 million shares of Snap on the open market.
However, the timing of a lock-up release off of the original terms must really be considered, particularly with respect to quiet periods and material matters in information as they relate to the company. After its December 2011 IPO, Zynga altered its lock-up agreement in early 2012 in order to stagger the shares over five separate stages. In the first stage, some executive insiders were released to sell shares before current and former employees. The price of Zygna shares collapsed just after this initial sale, leading to a flood of activity that unveiled an allegation that the insiders knew about prior to public disclosure. Zynga’s financial operating results were deteriorating, and they still were released from lock-up and sold a portion of their shares, which is what gave rise to claims of insider trading and breach of fiduciary duty.
When Facebook went public, the company established multiple lock-up dates. Facebook’s stock declined so much during these lock-ups that when the largest lock-up released, the stock price actually rose significantly, as shorts covered and investors who had been waiting on the sidelines took advantage of the deflated price. As the stock rose, this could also have given holders of the stock encouragement not to sell, which in turn could put more pressure on shorts.
It is becoming increasingly common to release shareholders early from lock-up provisions, but it is important to understand the entire picture and the number of unknowns when making these decisions. Predicting and understanding what a stock price will do leading up to and following a lock-up is a complex exercise. In addition to the laws of supply and demand combined with the recent and expected financial results of the company, one needs to anticipate the buying and selling activities of investors as well as short sale activities, general market sentiment and movement.
Our team is well-versed in IPO lock-up periods and the strategies surrounding them. Contact us today to schedule an appointment.
Debbie Kaster, Managing Director