What Is a Lock Up Agreement?

What are lock up agreements, and why are they essential during IPOs? 

Lock up agreements stop company insiders, like executives and early investors, from selling their shares right after an IPO. By limiting sales during this early period, they help prevent big price drops and keep the market stable. For companies, these agreements are key to boosting investor confidence and ensuring a smoother start in the public market. 

In this guide, we’ll break down how these agreements work, their impact on IPOs, and why they matter to both businesses and investors.

Defining Lock Up Agreements

Lock up agreement is a legal contract between a company and the insiders such as early investors, executives and employees who agree not to sell their shares for a given period after the company goes public through an initial public offering. Usually, this is any period between 90 and 180 days, so as to prevent a sudden burst of shares into the market, which otherwise would result in a dramatic fall in price. The agreement is of different length and terms, depending on the parties involved. 

Lock up agreements are created to keep insiders from selling large quantities of shares at once after the IPO, so as to prevent a surge in supply that would hurt the stock price. This mechanism protects the interests of the new investors by not letting their shares get prematurely undermined by heavy selling due to many large holdings. It gives the market an opportunity to judge the real worth of the company without an oversupply of shares affecting the judgment.

A public investor derives confidence that insiders have long term faith in the company’s growth potential through lock up agreements. They are a dam against short term speculation, they make traders think more, trade more measured. Although these agreements are most frequently found in IPOs, they can be found in secondary offerings or mergers. Lock up agreements are important to prevent a stock price collapse following a switch from private to public ownership, and to foster a sense of market trust that is so important to generate a positive market atmosphere. 

Mechanics of Lock Up Agreements

Lock–up agreements are contracts that have to be signed in connection with IPOs and other major equity events, where company insiders such as founders, executives, employees and early investors with large stakes in the company are affected. These agreements provide protection to stock price in the early trading period by preventing insiders from selling or transferring their shares for a definite period of time, say 90 to 180 days after the company’s initial public offering. 

These are agreements because, when a big block of shares hits the market at once, the stock price can plummet violently. Locking in insiders shares in the early days of trading stabilizes the market, allowing the company’s stock to find its true market value without the volatility brought on by insiders cashing out immediately after the IPO.

Venture capitalists, private equity firms, or other large shareholders may also have lock up agreements. These investors can sell their shares after the lock up period and if sold in large volumes can potentially affect the stock price. Some companies and underwriters release shares gradually to manage this, in order to reduce the risk of sharp price changes. 

The Strategic Importance of Lock Up Agreements

After an IPO, lock up agreements are very important to ensure market stability. Designed to safeguard the market from sharp price moves that could happen if large shareholders, such as insiders and early investors, could sell their shares immediately upon the company becoming public, they are. These agreements prevent a flood of shares from hitting the market and tanking the share price, thereby preventing volatility and souring investor confidence.

Lock up agreements place limitations on the sale of insider shares during a certain period, thereby ensuring an orderly and stable market during the first several days of trading. This provides the stock time to reach a natural price, dependent only on supply and demand, with the distortion of mass insider selling. This protection is key for investors as it protects them from being able to be manipulated by insiders purchasing their holdings and cashing out large portions of them as a result of the excitement and the cash that comes with an IPO.

Lock up agreements also have the positive effect of aligning the interests of insiders with longer term investors because they provide incentives for insiders to stay with the business during its vital post IPO period. It gives outside investors the comfort that insiders are essentially locked in the stock for a period of time, and thus have a vested interest in the company’s future success. The delay of selling also gives market participants a chance to evaluate the company’s real performance and fundamentals, hence making better investment decisions.

Lock up agreements protect the company and the investors against market instability, providing enough time for both the company and investors to adjust to the new public trading environment and lowering the risk of market disruptions in case of immediate insider sell-out. By mitigating these disruptions, lock up agreements can also help reduce exposure to systematic risk, as large, sudden sell-offs can ripple through the broader market and impact investor confidence beyond the company itself. 

Evaluating the Impact on Shareholders and Investors

Major shareholders and general investors are affected differently by lockup agreements and the consequences of those lockups for stock liquidity and price volatility. Lock up agreements prevent major shareholders in a company from selling shares for a period after an IPO, usually 90 to 180 days, including company insiders, venture capitalists and early investors. This certainly sounds like a negative but also guards against the price depreciation of these shares due to a sell off by these shareholders, allowing them to eventually sell in a steadier market.

Lock up agreements provide a measure of comfort for general investors in the immediate post IPO phase. An insider can’t sell their shares, which means there is little chance of a sudden flood of stock being put up for sale and driving prices down — and causing large losses. The restricted selling period allows the market to put a more organic valuation on the stock based on supply and demand by public investors, as opposed to big, fast sell-offs by insiders.

But when the lock up period ends, both main shareholders and average investors are vulnerable to much higher price volatility. The agreement usually expires, and the number of shares available for trading increases a lot, which means that the stock price can go down when more shares go on the market. These expiration dates are watched closely by investors — temporary price dips or swings can occur if large shareholders decide to sell a large part of their holdings.

Lock up agreements help steady the stock when it first begins trading but major shareholders and the general investing public must be aware of the volatility risk once the restrictions are lifted. The knowledge of these dynamics helps investors to better anticipate the stock’s performance during and after the lock-up period. 

Navigating Through Lock-Up Periods

Careful consideration of market conditions and a strategic approach to the management of risk and the pursuit of opportunities is necessary in navigating lock-up periods. You can first watch insider activity and news on the company before the lock up period ends to gauge sentiment among investors. If insiders have a lot of faith in the company’s long term growth, they’re not going to want to cash out as soon as the lock up period is over, which can be a ‘buy’ signal for the investor to stay in or get into the position. On the other hand, insider traits of intense selling pressure can foretell price volatility to come.

During the lock up period, it’s always good for investors to monitor the stock trading volumes and price fluctuations. Despite the restrictions on insider selling, prices can be relatively stable, but they get a lot of attention in the days surrounding the expiration date, with prices potentially swinging around either anticipation of a sell off or speculative buying. Other investors may choose to get out of the position just before expiration to spare themselves from a possible decline in the stock if a large number of shares flood the market.

Before lock-up expires, volatility normally decreases as people know that insiders can’t trade their shares; after lock-up expires, volatility usually increases as insiders may begin selling their shares. Experienced investors often start looking for opportunities to buy the dip when prices drop significantly and believe the selling pressure is short term and doesn’t reflect the company fundamentals. Some may be more conservative, waiting until the market stabilizes after lock-up before making new investment decisions.

In simple terms, the ability to not only stay the course but also take advantage of short term price dips during lock up periods is dependent on two things, being informed and understanding the sentiment of the market, and aligning your strategies to the long term prospects of the company. 

Case Study: Real-World Application

A notable example of a lock up agreement at work was during Uber’s IPO in May 2019. As Uber went public with a great deal of anticipation in the market, it had a lot of challenges in the months after the IPO. The lock up agreement was one of the most critical factors; it locked insiders, such as company executives and early investors, from selling their shares for 180 days post IPO. For the entirety of this lock-up period, Uber’s stock price waned, mainly on broader market worries and skepticism about Uber’s potential for profitability.

About a billion shares, or roughly 90 percent of Uber’s shares, became eligible to be sold when the lock up expired in November 2019. As expected, many insiders used the opportunity to liquidate their positions and accordingly the selling pressure escalated. Uber’s stock fell more than 7% on the first day after the lock-up expiration, to an all time low at the time.

This case highlights the fact that lock up expirations can be a source of volatility, as insiders typically want to cash out of their equity holdings in high profile IPOs. The end of the lock-up also underscores the significance of investor sentiment — with the lock-up still in place, investors were already wary about Uber’s financial issues, and the end of the lock-up made fear of oversupply in the stock market worse.

The lessons of Uber’s experience highlight the importance for investors to be careful around lock-up expirations, especially in companies between a rock and a hard place financially. Such events can exert tremendous downward pressure on stock prices, making it essential for investors to consider strategies for downside protection, such as stop-limit orders or hedging. Yet, they can also provide opportunities to buy for long-term investors if fundamental strength in the company persists through the volatility.

Advantages of Adhering to Lock Up Agreements

Lock up agreements offer a number of important benefits for both the issuing company and investors, especially in the context of IPOs. Market stability is one of the main advantages. Lock up agreements prevent insiders from selling large quantities of shares soon after the stock begins trading, which helps keep prices stable while a new public company’s stock is traded for the first few days. This allows sudden, sudden drops in the stock price from a larger number of shares dumped into the market to be avoided. It creates stability that gives investors confidence that the market will not suddenly adjust the new stock’s value, but will do so over time without an excessive amount of volatility.

Lock–up agreements are also good for the company, as they show the will of the company to be successful for a long period. Essentially, insiders—executives and early investors, for example—are voting with their feet by agreeing to stay invested in the company for an extended period of time. This can create trust with new investors who might be more likely to invest in the company knowing that those most close to operations are not planning on selling their holdings right away.

Lock up agreements, in addition, can bring a certain scarcity in the market. Since only a limited number of shares are available to trade, it may be possible for demand to exceed supply, causing the stock price to rise in the weeks and months following an IPO. This might make the company’s value seem better in the market. And in turn, it can help build up the company’s reputation and help with better long term pricing as it continues to mature in the public markets. Thus, the discipline of a lock up agreement can therefore provide a more stable and prosperous transition to public trading for both the company and its shareholders. 

Drawbacks and Limitations

Although lock up agreements help stabilize markets they are rife with drawbacks for both insiders and external investors. Shareholder freedom is one major concern. Lock-ups are designed to prevent insiders—executives, employees, early investors—to sell their shares during the agreed period even if they need liquidity, or the stock price goes up. This is frustrating for those who waited years to make money from the IPO.

Yet another key issue is the risk for a sharp sell off on the expiration of the lock up. The problem is that if a large number of insider shares become available all at once, the surge in supply can drive down the stock price. New investors are often caught unaware by this post lock up dip, and end up taking short term losses. The purpose of a lock up is to delay volatility, but it can only delay it, and what happens is that you have pent up selling pressure and then you get the sharp decline when the lock up ends.

Lock up agreements can also inadvertently signal negative to the market. Assuming that shares would be sold immediately if restrictions didn’t exist, investors could read them as an indication that insiders don’t believe in the company’s long term prospects. Damage to investor sentiment is a result of this perception. Moreover, lock-ups are rigid that may discourage potential hires or new investors who place a significant value on flexibility in stock compensation options.

Lock-ups are a double-edged sword, intended to insulate the market during IPOs, but with unintended consequences, they can delay volatility, restrict liquidity, and leave markets skeptical of the company and its shareholders. For investors navigating these challenges, stock alerts can serve as a valuable supplementary tool, helping them respond quickly to market shifts and adjust strategies effectively as lock-up expirations approach. 

Conclusion

Lock up agreements are important in maintaining stability of stock post IPO as it prevents insiders from immediately selling off their shares. This makes the investor confident and maintains market stability during early months of a company’s public life. Lock up agreements simply enforce a temporary hold on insider stock sales to protect new investors and prevent volatility.

Still, these agreements aren’t problem free. Insider liquidity is limited and the market is exposed to a sell off when the lock up period ends. Despite these deficiencies, lock up agreements provide a valuable mechanism for striking the fine line between protecting investors and ensuring orderly markets, to the mutual benefit of the issuing company and the broader investor community. 

Lock Up Agreement: FAQs

How Long Do Typical Lock-up Periods Last?

Most lock up periods are 90 — 180 days after an IPO. This is also referred to as a lock up period, whereby insiders, such as company executives and early investors, are restricted from selling their shares so that there isn’t a sudden flood of stock entering the market which could destabilize the price. The duration, however, depends on specifics of the agreement and the company’s strategic goals.

Can a Lock up Agreement Be Waived or Modified?

Yes, a lockup agreement can be waived or modified under some circumstances. This usually needs the underwriters or company management approval. Insiders are allowed to sell a portion of their shares (waivers or modifications are granted) earlier, typically if the stock price is doing well, or in special situations (i.e. merger or acquisition).

What Happens If a Shareholder Breaks a Lock up Agreement?

Breaking a lock up agreement can have serious legal consequences, even lawsuits, and penalties. Additionally, the violation could damage the reputation of the company and its loss of trust with both investors and regulators. Mostly the agreement is strictly adhered to so as to avoid these outcomes.

How Do Lock up Agreements Affect Stock Prices in the Long Term?

Lock up agreements can be helpful in the long term to avoid short-term volatility post-IPO but can result in a temporary drop in stock price when the lock-up expires. This is because insiders are free to sell, which increases the supply of shares and often leads to a spike in implied volatility as the market anticipates potential price swings. However, if a company’s fundamentals are still strong, the long-term effect on stock prices may

Are Lock up Agreements Standard in All IPOs?

Yes, lock up agreements are typical of most IPOs. The theory is that they protect new investors from large price drops caused by insiders unloading large quantities of stock. The lock up agreement is common practice to keep things stable when moving from private to public markets but the exact terms and length can vary.