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Lock-up Agreement

A legally binding contract between the insiders and underwriters of a company prohibiting the sale of its shares within a specified period

What is a Lock-Up Agreement?

A lock-up agreement refers to a legally binding contract made between the insiders and underwriters of a company during its initial public offering (IPO) that prohibits them from selling any of their shares for a set period of time. These individuals may include venture capitalists, company directors, managers, executives, employees, and their family and friends.

 

Lock-up Agreement

 

A lock-up period normally lasts 180 days, or six months, but may last anywhere from four months to a year. Since there are usually no federal laws governing lock-up agreements, the decision on the duration is usually made by the underwriter.

 

Importance of Lock-Up Agreements

Before a company is allowed to go public, underwriters will require insiders to sign a lock-up agreement. The purpose is to maintain the stability of the company’s stocks during the first few months after the offering. The practice provides an orderly market in the company shares following the IPO. It allows enough time for the market to find out the real worth of the stock. It also ensures that the insiders carry on acting in line with the firm’s goals.

During the sale of a controlling stake, the company acquirer at times needs to agree to a lock-up clause. It forbids the resale of the assets or stake for the duration of the agreed lock-up period. The move is intended to maintain price stability for other stakeholders.

Companies under hostile takeovers sometimes explore a similar route. The restricted or “locked” stakeholders are only allowed to sell their stocks after the end of the lock-up period. This helps prevent the opportunistic behavior of some insiders that would want to sell the shares at a lower price.

 

Impact of Lock-up Agreements on Investors

Lock-up agreements are intended to provide investors with protection. The lock-up agreement tries to avoid a scenario where a group of insiders make public an overvalued company and dump it on investors, running away with the profits. Individuals with plans to invest in the company need to determine the time that the lock-up period will end. This because insiders selling some of their shares may initiate downward pressure on the company’s stock.

The lock-up agreement may include additional clauses that limit the number of shares that can be sold during a specified time period after the expiration of the lock-up agreement. Such clauses help prevent a significant decline in share prices that may ensue from a huge increase in supply.

Investors need to know if there is a lock-up agreement since there is a high probability of a stock price drop when the lock-up agreement expires.

 

Key Takeaways

Underwriters and insiders in IPOs agree on lock-ups to prevent insiders from opportunistically selling their stock within a given time window.

The lock-up agreement helps to ease volatility pressure when the company’s stock is in its first few months. It is only after the expiration of the lock-up period that the insiders are free to sell.

Lock-up agreements are of concern to investors since the terms can influence the stock’s price. After the expiration of the lock-ups, restricted people are allowed to sell their stock. When a significant number of insiders exit, the result can be a drastic decline in the share price.

 

Additional Resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Investing: A Beginner’s Guide
  • FAANG Stocks
  • Sale and Purchase Agreement
  • Trade Order Timing

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