By Joanne Hue, Last updated: 2023-01-11 (originally published on 2022-03-15)
What Is a Lock-Up Agreement?
A lock-up agreement is a provision in an agreement that prohibits or restricts the selling of shares by insiders of the company for a specified period. Generally, they are a part of the initial public offering process. In order to prevent excessive selling pressure in the initial months of trading following an IPO, the underwriters require executives, venture capitalists, and other company insiders to sign lock-up agreements.
How do Lock-Up Agreements work?
Such agreements usually last for a period of 180 days but can occasionally go on for 90 days or even a year long. It is possible for all insiders to be locked up for the same period of time. In other cases, different classes of insiders are locked out for different periods of time. The prospectus documents of a company always disclose the details of a company’s lock-up agreements. These can be obtained by contacting the company’s investor relations department or by using the Securities and Exchanges Commission’s (SEC) Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database.
The main objective of a lock-up agreement is to prohibit company insiders from discarding their shares to new investors after the initial months of an IPO. Early investors such as VC firms could be some of these insiders who bought into the company when it was worth significantly less than its IPO value. So, to realize the gain on their initial investment, they may have a strong incentive to sell their shares.
Similarly, stock options may be given to company executives and certain employees as part of their employment agreements. These employees may also be enticed to exercise their options and sell their shares as the price of the IPO will be more than the exercise price of their options.
From the regulatory point of view, these agreements are there to protect investors. Such agreements are meant to avoid situations where insiders throw away their shares on the company investors and run away with the proceeds.
In cases where a lock-up agreement is in place, it can still affect investors who are not company insiders once the lock-up agreement runs past its expiration date. On the expiration of a lock-up agreement, the company insiders are permitted to sell their stock. There can be a huge drop in the share price due to a high increase in the supply of stock when many venture capitalists and insiders are looking to exit.
This can be looked up in two ways by an investor depending upon their view about the quality of the underlying company. Where the post-lock-up drop occurs, this can be an option to buy shares at a lower price or temporarily depressed price. On the other side, it can also be understood that the IPO was overpriced, signaling the start of a long-term decline.
Additional clauses may be added in a lock-up agreement that limits the number of shares which can be sold for a specific period after the expiration of the lock-up agreement. This will help in preventing a huge dip in the share price which results from the high demand in supply. It is important for investors to know about the probability of a stock price after the expiration of a lock-up agreement.
Example of a Lock-Up agreement
Generally, the expiration of a lock-up agreement is followed by a period of abnormal returns. Such abnormal returns are usually in the negative direction for the investors. It has been noticed by various studies that a stock is more affected by staggered lock-up agreements than that with a single expiration date. This is astonishing as staggered lock-up agreements are often seen as a solution to the post-lock-up dip.
Termination of Lock-Up Agreement
The parties will be released from their obligation upon the termination of lock-up agreements. This happens when the company elects not to pursue the offering, or if a certain drop-dead date for the offering has passed.
In almost all IPOs, the prospectus of a company discloses whether all or some IPO shares have been locked up. The shares which have been acquired through a directed share program will also be affected by the IPO lock-up.
Lock-up agreements in follow-on offerings, which are often completed much more quickly than IPOs, will usually be obtained only from the issuer and its directors and officers. The other stockholders are not advised by the issuers about a contemplated offering since that itself may constitute material nonpublic information (MNPI), and stockholders generally would not want to receive MNPI as that would prohibit them from trading the issuer’s securities.
Lock-Up Agreements and Carve-Outs
There is acknowledgment and agreement in the case of customary lock-up that a party will not:
- Offer, sell, contract to sell, pledge, or grant any option to purchase or otherwise dispose of (collectively, a disposition) any company securities or any securities convertible into or exercisable or exchangeable for, or any rights to purchase or otherwise acquire, any company securities held by or acquired by the lock-up party, or that may be deemed to be beneficially owned by the lock-up party.
- Exercise or seek to exercise or effectuate in any manner any rights of any nature that the lock-up party has or may have to require the company to register the lock-up party’s sale, transfer, or other disposition of any of the lock-up shares or other securities of the company held by the lock-up party, or to otherwise participate as a selling security holder in any manner in any registration affected by the company.
The lock-up party also agrees not to engage in any hedging, collar (whether or not for consideration), or other transaction that is designed to or reasonably expected to lead or to result in a disposition of lock-up shares during the lock-up period, even if such lock-up shares would be disposed off by someone other than the holder. The prohibited hedging or other similar transactions would include any short sale or any purchase, sale, or grant of any right (including any put or call option or reversal or cancellation thereof) with respect to any lock-up shares or with respect to any security (other than a broad-based market basket or index) that includes, relates to, or derives any significant part of its value from the lock-up shares.
The following exceptions are generally agreed upon by the underwriters:
- Transfers of shares as a bona fide gift, including gifts to charitable organizations.
- Transfers of shares to a trust for the direct or indirect benefit of the lock-up party or such party’s immediate family.
- Transfers by will or intestacy to legal representatives, heirs, or legatees.
- Transfers pursuant to a domestic order, divorce settlement, or other court order.
- Transfers of shares of common stock or any security convertible into or exercisable for common stock to the company under any company right of repurchase or right of first refusal over such securities, or transfers of shares of common stock to the company for the net exercise of options.
- Distributions of shares to members, limited partners, or stockholders of the lock-up party.
- Transfers to affiliates or to any investment fund or other entity controlled by or managed by the lock-up party.
- Transfers of shares to the company as forfeitures to satisfy tax withholding and remittance obligations of the lock-up party in connection with the vesting or exercise of equity awards granted under the company’s equity incentive plans or under a net exercise or cashless exercise by the stockholder of outstanding equity awards pursuant to the company’s equity incentive plan.
Generally, the lock-up applies only to pre-IPO shares and not to shares bought in the open market in or following the offering (provided that such sales are not required to be reported in any public filing, and the lock-up party does not otherwise voluntarily make any public filing regarding the sales). Any grant or exercise of options pursuant to the company’s stock option plans or the exercise by the lock-up party of any warrant to acquire shares is not restricted by the lock-up provided that such shares are not transferred during the lock-up period.
From the above discussion, it can be concluded that the lock-ups are agreed upon by the underwriters and insiders in IPOs to prevent insiders from selling their stock for a specified period. This helps to ease the company’s pressure during its initial years as insiders are only allowed to sell after the expiry of the lock-up period. Lock-up agreements have a great influence on the investors as their provisions can have a great impact on the stock price.