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) to prohibit them from selling any of their shares during the transition for a set period of time. Company insiders prohibited by the lock-up agreement from selling any of their shares for a specified time may include venture capitalists, company directors, managers, executives, employees, and their family and friends.
A lock-up period normally lasts 180 days or six months but sometimes it can last for as little as four months or as long as one year. Since there are usually no federal laws governing lock-up periods, the decision to determine the duration of a lock-up agreement is usually made by the underwriter.
Importance of Lock-Up Agreements
Before a company is allowed to go public, underwriters will require insiders sign a lock-up agreement 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, thus allowing enough time for the market to find out the real worth of the stock. It also ensures that the insiders, in case of an IPO, as well as the acquirer, in the case of a controlling stake a sale, carry on acting in line with the firm’s goals.
During the sale of a controlling stake, the company acquirer is at times needed to agree to a lock-up clause that 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. It 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. Investors with existing plans to invest in the company or hold their shares after the closing of an IPO need to determine the time that the lock-up period will end since insiders may want to sell some of their company holdings, initiating selling pressure in the market for the company’s stock.
The lock-up agreement may also include additional clauses that can also limit the number of shares that can be sold in a specific duration after the expiration of the lock-up agreement. The clauses also lead to the prevention of a significant decline in share prices that may ensue as soon as the lock-up agreement expires due to a huge increase in stock supply.
Before investing, investors need to know whether the firm is under a lock-up agreement since there is a high probability of a stock price drop as soon as the lock-up agreement expires.
Underwriters in IPOs and insiders from the issuing company agree on lock-ups to prevent the insiders from opportunistically selling their stock within a given time window after the IPO since they might possess information that the company is overvalued.
The lock-up agreement helps to ease the volatility pressure when the company’s public trade is in its first few months. It is only after expiration of the lock-up period that the insiders will be free to sell, although they may need to consider the insider regulation prevailing in the country.
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 venture capitalists and insiders are considering to exit, the result can be a drastic decline in the share price because of the substantial rise in the supply of the stock.
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