Lock-Up Agreement

What Is a Lock-Up Agreement?

A lock-up agreement is a contractual provision preventing insiders of a company from selling their shares for a specified period of time. They are commonly used as part of the initial public offering (IPO) process.

Although lock-up agreements are not required under federal law, underwriters will often require executives, venture capitalists (VCs), and other company insiders to sign lock-up agreements in order to prevent excessive selling pressure in the first few months of trading following an IPO.

How Lock-Up Agreements Work

Lock-up periods typically last 180 days, but on occasion can be as brief as 90 days or as long as one year. Sometimes, all insiders will be "locked out" for the same period of time. In other cases, the agreement will have a staggered lock-up structure in which different classes of insiders are locked out for different periods of time. Although federal law does not require companies to employ lock-up periods, they may nevertheless be required under states' blue sky laws.

The details of a company's lock-up agreements are always disclosed in the prospectus documents for the company in question. These can be secured either 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 purpose of a lock-up agreement is to prevent company insiders from dumping their shares on new investors in the weeks and months following an IPO. Some of these insiders may be early investors such as VC firms, who bought into the company when it was worth significantly less than its IPO value. Therefore, they may have a strong incentive to sell their shares and realize a gain on their initial investment.

Similarly, company executives and certain employees may have been given stock options as part of their employment agreements. As in the case of VCs, these employees may be tempted to exercise their options and sell their shares, as the company's IPO price would almost certainly be far above the exercise price of their options.

Special Considerations

From a regulatory perspective, lock-up agreements are meant to help protect investors. The scenario that the lock-up agreement is meant to avoid is a group of insiders taking an overvalued company public, then dumping it on investors while running away with the proceeds. This was a real issue during several periods of market exuberance in the United States and is the reason why some blue sky laws still have lock-ups as a legal requirement.

Even when a lock-up agreement is in place, investors that are not insiders to the company can still be affected once that lock-up agreement runs past its expiration date. When lock-ups expire, company insiders are permitted to sell their stock. If many of the insiders and VCs are looking to exit, this can result in a drastic drop in the share price due to the huge increase in the supply of the stock. 

Of course, an investor can look at this in two ways, depending on their perception of the quality of the underlying company. The post-lock-up drop, if it indeed occurs, can be an opportunity to buy shares at a temporarily depressed price. On the other hand, it can be the first sign that the IPO was overpriced, signaling the start of a long-term decline.

Example of a Lock-Up Agreement

Studies have shown that the expiration of a lock-up agreement is generally followed by a period of abnormal returns. Unfortunately for investors, these abnormal returns are more often in the negative direction.

Interestingly enough, some of these studies found that staggered lock-up agreements can actually impact a stock more negatively than those with a single expiration date. This is surprising, as staggered lock-up agreements are often seen as a solution to the post-lock-up dip.