Source: SoFi Learn
If you’re an early investor in a company that’s about to go public, you might be expecting to hit it big if the value of your stock skyrockets after the IPO. If you choose to cash out, all you have to do is sell your shares and reap the rewards, right? Not so fast—after an IPO, many companies will tie your stock up in a lock-up period to keep you from cashing out too quickly.
What Is an IPO Lock-up Period?
The IPO lock-up period is the length of time after a company goes public, during which, some early investors in the company aren’t 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 required by the investment banks that are underwriting the process.
Depending on a company’s needs, the lock-period can be any length of time, but usually is between 90 and 180 days after the IPO. Companies may also 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.
When a company makes an IPO, or initial public offering, it is offering shares of the company for sale on the open market for the first time. The company is shifting at this point from a privately held company to a publicly traded company. This is the origin of the phrase “going public,” which you may have heard bandied around in reference to IPOs.
When a company is private, ownership is limited and can be tightly controlled. But when a company goes public, anyone can buy shares. But at this point there may be a lot of fingers in the pie already. Company founders, early employees, and even venture capitalists may already own shares or have stock options in the company.
A company or its underwriters might use the lock-up period as a tool to bolster the share price during the IPO.
Also worth noting, before a company goes public it often goes through an underwriting process in which an underwriter—usually an investment bank—structures and supports the IPO. The most common way they do this is by agreeing to buy a company’s entire inventory of stock.
Then to alleviate the risk of holding all of this stock, the underwriter will allocate shares of the company to institutional investors before the IPO. The underwriter will try to drum up so much interest in the stock that more people will want it than there are shares available. This will lead to the stock being oversubscribed , which will hopefully support its price when it hits the market.
A company or its underwriters might use the lock-up period as another tool to bolster the share price during the IPO. Shares held by the investment bank or institutional investors can be sold during an initial public offering, but the shares held by company insiders—including founders, executives, employees, and venture capitalists—may be subject to a lock-up period. This restrictions means that these shareholders are not able to sell their stock until this period is over.
Why Do Lock-up Periods Exist?
Insiders, like employees and early investors, can potentially own far more shares in a company than are initially available to the general public. The last thing a company wants during an IPO is to have these extra shares flood the market.
Since share price is set by supply and demand, extra shares can drive down the price of the stock. And that’s not a good look, especially when a company is trying to impress investors and raise capital.
Company insiders may face other restrictions beyond the lock-up period. That’s because they might have information that can help them predict how their own stock might do that is not available to the general public.
Though insider trading can be legal if properly controlled and documented, it is not legal when based on information the public doesn’t have yet. So, depending on when a lock-up period ends, company insiders may have to wait extra time before selling their shares. For example, if a company is about to report its earnings around the same time a lock-up period is set to end, insiders may have to wait for that information to be public before they can sell any shares.
Finally, lock-up periods can 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 dump their stock, investors may get suspicious and be tempted to sell their shares as well. As demand falls, so too does the price of the stock.
Even if the insiders were trying to cash in their stocks for no other reason than simply wanting the money, public perceptions may change and damage the company’s reputation. The lock-up period may have an effect by keeping this from happening—at least while the newly public company gets off its feet.
What’s an Example of a Lock-up Period?
For example, Snap, the parent company of social media app Snapchat, went public with an IPO on March 2, 2017. 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.
As new shares hit the market the stock dropped by as much as 5%, and it closed the day down just over 1%. A second lock-up expired in August of 2017, 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.
Facebook is another highly publicized example of the use of a lock-up. The company made its initial public offering in May of 2012. After its first lock-up expired three months later, 270 million shares of the company were allowed to flood the market.
Shares of the stock dropped to $19.69, which was nearly half of its debut price of $38 . The company went on to four more lock-up dates that meted out nearly 1.7 billion shares of the company.
What Does the Lock-up Period Mean for Employees with Stock Options?
Restrictions imposed during a lock-up period usually apply to any stock options someone has been given as an employee before an IPO. Stock options are essentially an agreement with a company that allows its employees to buy stock in the company at a predetermined price.
The thinking behind this type of compensation is that the company is trying to align employees’ incentives with its own. Theoretically, by giving employees stock options, the employees will have an interest in seeing the company do well and increase in value.
There’s usually a vesting period before employees can exercise their stock options, during which the value of the stock can increase. At the end of the vesting period, employees are able to exercise their options, sell the stock, and keep the profits.
It’s possible that the company will issue stock options before it goes public. If stock options vest before the IPO, employees may have to wait until after the lock-up period to exercise their options. However, stocks may not vest until after the lock-up period, in which case the restrictions don’t have much bearing on the employee’s ability to exercise their stock options.
What Does a Lock-up Period Mean to the Average Investor?
As a regular investor, you likely don’t have access to shares of a company before it goes public. Even so, you still might want to pay attention to the lock-up period. Investing in IPOs can be tricky and are generally considered risky.
The underwriters will do everything they can to make sure that stock prices goes up when company shares hit the market. But in the end, no one really knows what will happen during an IPO. Share prices could soar sky high or they could fall.
What’s more, investors interested in buying a stock that’s about to go public don’t really have much information to go on to help them figure out what kind of value they’re getting. When they’re private, companies don’t have to divulge very much information about their inner workings to the SEC.
However, before going public they will make documents available, including the Form S-1 and the red herring prospectus that can give investors some clues about a company’s business model and what they plan to do with the money they raise. Investors can also look at what happened when similar companies went public and whether they did well.
When the lock-up ends, the stock price may experience some volatility as the new shares enter the market.
This is all to say that with little idea of what a company’s stock will do when the company goes public, regular investors may want to hold off before they invest. Investors may even want to hold off until the lock-up period is over.
When the lock-up ends and insiders and employees can finally sell their shares, the stock price may experience some volatility as the new shares enter the market, potentially causing drops in a stock’s price.
Some investors may try to take advantage of the dip that can occur when a lock-up period ends. For example, if investors see that a company’s financial health is good during the first stages of it’s public life, they may use the expiration of the lock-up period as a chance to buy shares at a “discount.”
They may feel that if the stock’s fundamentals were good before the lock-up ended, the company is in good financial health and the stock should rebound. Timing the market like this isn’t necessarily for all investors, especially those not used to taking a deep dive into the fundamentals of a company’s financials. It’s also not guaranteed to produce good results.
Where Do IPOs Fit into Your Portfolio?
An IPO can be hard to navigate. Yet, they can be really exciting for investors looking to get in on the ground floor and employees or insiders looking to cash in on their shares or stock options.
Yet, amid all that excitement, it’s important for investors to consider how an IPO will affect their portfolio. Holding too much of any one stock can open investor portfolios up to market risk. For example, if that single stock—which could be stock in your own company stock—does poorly, it can have an outsized effect on your portfolio returns.
So employees who hold a lot of company stock may consider selling shares after the lock-up period to help them add diversity to their portfolio. They may decide to use proceeds from the sale to buy other assets to help them keep their portfolio in balance.
Similarly, investors looking to buy shares after an IPO will likely want to make sure that doing so fits into their own asset allocation, the balance of stocks, bonds, and other assets that they hold.
When building a portfolio, investors can enlist the help of a financial advisor or invest themselves. They may also use an automated investing service that build portfolios based on their goals and financial situation.
If you’re ready to learn more about investing or starting building a diversified portfolio to help you meet your goals, try SoFi Invest®.