Lock-Up Agreement: Definition, Purpose, and Example

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 not required under federal law, underwriters often require executives, venture capitalists (VCs), and other company insiders to sign lock-up agreements to prevent excessive selling pressure after an IPO.

Key Takeaways

• A lock-up agreement temporarily prevents company insiders from selling shares after an IPO.
• It protects investors against excessive selling pressure by insiders.
• Share prices often decline after the expiration of a lock-up agreement, providing an opportunity for new investors to buy at lower prices.

How Lock-Up Agreements Work

Lock-up periods typically last 180 days but can occasionally be as brief as 90 days or as long as one year. Sometimes, all insiders will be "locked out" for the same period, while in other cases, the agreement will have a staggered lock-up structure with different classes of insiders being locked out for different periods. While federal law does not require companies to employ lock-up periods, they may still be required under states’ blue sky laws.

The details of a company’s lock-up agreements are always disclosed in the prospectus. This information can be obtained by contacting the company’s investor relations department or by using the Securities and Exchange Commission’s (SEC) Electronic Data Gathering, Analysis, and Retrieval (EDGAR) database.

The purpose of a lock-up agreement is to prevent insiders from selling their shares shortly after an IPO. Some insiders may be early investors such as VC firms, who bought into the company when its value was significantly lower than the IPO price. 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. In the case of VCs, these employees may be tempted to exercise their options and sell their shares since the IPO price would likely exceed the exercise price of their options.

Special Considerations

Lock-up agreements are meant to help protect investors from insiders taking advantage of an overvalued company during an IPO. This was a significant issue during periods of market exuberance in the United States and is why some blue sky laws still require lock-ups.

Even when a lock-up agreement is in place, non-insider investors can be affected once it expires. When lock-ups expire, insiders are allowed to sell their stock. If many insiders and VCs aim to exit, this can result in a drastic drop in the share price due to the increased supply of the stock.

An investor can interpret this drop in two ways, depending on their perception of the underlying company’s quality. It can be an opportunity to buy shares at a temporarily depressed price or a signal that the IPO was overpriced, indicating 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, often in the negative direction for investors.

Surprisingly, some studies found that staggered lock-up agreements can have a more negative impact on a stock than those with a single expiration date. This contrasts with the belief that staggered lock-up agreements can solve the post-lock-up dip.

Surprisingly, some studies found that staggered lock-up agreements can have a more negative impact on a stock than those with a single expiration date. This contrasts with the belief that staggered lock-up agreements can solve the post-lock-up dip.