The purpose of such a covenant--at least in theory--is to limit trading volatility and maintain a loyal, stable shareholder base. Essentially, underwriters who put up cash to buy shares in an offering are looking to avoid a massive share dump once the deal is done.
Since 1996, more than 90 percent of IPOs have adopted some type of lock-up agreement.
The trend is to include a lock-up agreement within a company's prospectus, but there has been a decline in the average number of days that the agreement can remain in effect. Since 1990, a typical lock-up agreement totaled nearly 250 days, or about eight months. Insiders and executives that participated in an IPO in June 1997, for example, wouldn't be able to sell shares until February 1998.
In 1994, the typical lock-up agreement was 275 days, or about nine months. After that, the average length of lock-up periods began to decline. In 1999, the average lock-up agreement fell to less than 180 days.
This reduction in the number of no-trade days corresponded with an unprecedented appreciation in IPOs on their opening trading days. Some market observers maintain that it is to the advantage of insiders to shorten the lock-up period to capitalize on the enormous price gains of many new offerings.
It should come as no surprise, then, that as IPO prices have risen significantly, there has been a corresponding decline in the average duration of lock-up agreements.
Executive compensation also has been a factor in shortening the length of lock-up periods. Since many employees of Internet start-ups are often wooed with stock options to join the firm, it's not uncommon to see an executive from a successful newly public firm as a millionaire on paper but a pauper at the bank. Shortening lock-up periods allows employees to readily cash out.
Conversely, there are arguments that lock-up agreements aren't designed to keep insiders from selling early but are intended to limit the available supply of stock on the open market, artificially driving up the share price and locking out smaller investors.
For example, the results of a study by Michael McBain and David Krause published in a 1989 article in the Journal of Business Venturing maintained that an IPO stock price is directly related to the proportion of insider ownership. The premise is that lower insider ownership indicates higher risk and adversely affects share price. Thus, as long as insiders maintain their level of ownership, outsiders will have no choice but to bid shares higher.
Research has shown
IPOs with lock-up provisions
|IPOs with lock-up provisions*||Percentage of all IPOs||Avg. days before expiration|
* excludes closed-end funds
Source: Securities Data Corp.
In nearly every case, those IPOs with shorter lock-up agreements didn't fare better than the typical IPO.
For example, Salon.com--which priced at $10 per share--had a 90-day lock-up period in force. However, by the expiration day the shares had already dropped more than 40 percent from their first day of trading. IPOs with average lock-up agreements of 90 days gain approximately 13.1 percent by the time the lockup expires. That compares to a 26.2 percent gain, on average, for IPOs whose lock-up agreement came to an end 180 days after an offer date.
These results may be affected by the high number of IPOs with 180-day lock-up periods, compared to those with shorter durations. Nonetheless, several facts are irrefutable.
First, the average length of a lock-up agreement has been declining. Second, the number of IPOs with 90-day or shorter lock-up periods has increased. Finally, venture-backed IPOs typically will have shorter lock-up periods than those not backed by such funding.
For example, of the 77 IPOs that were supported by venture capital in 1998, the corresponding lock-up periods averaged 184 days, compared to an average of 239 days for IPOs without funding. The following year, VC-supported IPOs averaged a lock-up period of 177 days, while others averaged 192 days.
One reason the length of lockups has dropped is that venture capital firms and institutional owners are less willing to keep their full investment intact for any extended period. As one money manger noted, the current IPO market is one where venture funds must quickly return some of their gains so partners can churn out more deals to remain competitive.
In part, the rapid appreciation of IPOs in the past few years has made it imperative for institutions to "lock in" gains so they can document a strong return to their own investors and complete the cycle--gather more capital to fund more IPOs. Hence, the lock-up period gets shorter as institutions look to bolt from their investments and seek the next deal.
But what happens after a lock-up period expires? An examination of recent IPOs shows that among those priced in 1999 with lock-up agreements of 180 days, the average gain at the time of expiration was approximately 85 percent.
Since that time, however, those issues with expired lock-up provisions have collectively registered an average gain of over 126 percent since their offer date. This indicates that removing a lock-up agreement does little to diminish investor support.