Locked In What it Means How it Works Reasons

Locked In What it Means How it Works Reasons

Locked In: Meaning, Function, and Reasons

Definition of Locked In

Locked in refers to when an investor is unable to trade a security due to regulations, taxes, or penalties. This can occur in investment vehicles like retirement plans that have specific withdrawal restrictions.

Key Takeaways

  • Investors become "locked in" when they are unable to trade a security due to regulations, taxes, or penalties.
  • Employee incentive programs may include stocks, options, and warrants with mandatory vesting periods, which can also become locked in.
  • IPO shares are often locked in to prevent unfair trading advantages for insiders.

Understanding Locked In

If the value of stocks owned by an individual increases, they will be subject to a capital gains tax. To reduce this tax burden, investors may choose to shelter the gains in a retirement account. This results in the individual being locked in because withdrawing a portion of the investment before maturity incurs higher taxes.

Locked-in securities can include stocks, options, and warrants offered under employee incentive programs. These programs promote loyalty and strong performance by implementing mandatory vesting periods. During these periods, employees have been granted the securities but cannot exercise them yet (meaning convert them to cash or stock).

Typically, these shares or warrants must be held for several years before they can be exercised. There may be phases within the locked-in period where the shares change ownership or tax status at stipulated intervals.

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Even after options or warrants are converted into stock and granted to an employee, there may be an additional holding period before they can be sold. Employees usually receive the options at the market price when granted, which may be lower than the market price when they are exercised. Depending on the timing of the stock sale, the proceeds may be taxed at a lower initial rate.

Reasons for Locked-In Shares

During an initial public offering (IPO), shares held by founders, promoters, and early backers of a company may be subject to lock-in stipulations. This prevents company insiders from selling or transferring shares while they possess advantageous information that outside investors do not.

The lock-in period may last for 90 days or several years after the IPO, reducing the possibility of insider manipulation by restricting their trades.

Executives and senior management may also receive locked-in shares as compensation. These shares are not released immediately, encouraging sustained superior performance.

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