When companies "go public", the number of shares offered in the initial public offering (IPO) is typically a relatively small portion of the overall ownership. The balance of the shares is held by insiders, which include management, founders and venture capitalists (VC) who funded the company while it was private.
Although the number of shares offered will differ from one IPO to another, nearly all IPOs have some sort of lock-up period. A lock-up period is a caveat placed on insiders and pre-IPO holders that prevents them from selling their shares for a set period of time after the company has gone public. A typical lock-up period is four to six months. For example, Twitter's IPO, which debuted on November 7, 2013, has a lock-up period of 180 days. This means that Twitter's executives and directors won't be able to sell their shares until 180 days after the November 7 IPO date.
There is no federal law or Securities and Exchange Commission requirement that forces insiders or pre-IPO shareholders to be "locked up," but the investment banks underwriting the IPO almost always request it so that insiders do not flood the market with shares right after the company's initial public offering.The lock-up in the prospectus (Form 424B4) is a contract between the insiders and the purchasers of the IPO, so it is highly unlikely that it would be violated.
This information is disclosed in the S-1 when the IPO documents are filed with the SEC. The best sources for lock-up information are the SEC website and several paid services including Edgar Online. The lock-up period will be stipulated in the prospectus, called the S-1, but it is very important that investors watch each revision of this document, called S-1/As, because there could be a change in the lock-up terms.
The Reason for Lock-ups
As a company goes public, underwriters want to be able to see what outside investors believe the new entity is worth based on information like that found on the balance sheet, the income statement (profits and losses) and executive overviews of the business (business risks).
If inside investors are allowed to sell immediately at the time of the IPO, it may well obscure the price that the markets put on the company by putting selling pressure on the shares on the first day of trading.
The Positives of Insider Sales
The end of the lock-up period is as important as an earnings report or other big event at a public company. There are several factors that investors should watch for to determine whether post lock-up selling is a warning sign.
First, determine how long inside investors have had shares. Some founders may have been with companies for several years, so the sales of their shares may be the only way that they have to make significant money from their work. Both the S-1 and proxy show terms of service for officers.
Another factor to consider is whether a venture capitalist has one of its partners on the company's board of directors. If so, the VC firm may be less likely to sell because of a concern that the board member could have inside information about the company's activities. This also holds true for officers. Quite often a lock-up period will end, but insiders cannot sell stock because they have information on earnings or have access to other critical data that the public shareholders do not.
Insiders are probably more likely to sell if a stock has gone up sharply since the IPO. There is no hard data on this, but shareholders in a company with a falling share price post-IPO do not want to add to investor concerns by selling shares.
Remember, insider selling after a lock-up period is not necessarily bad. As said above, often company management has worked for a number of years to build the business, and its entire net worth is tied up in the value of the firm. There is also the fact that venture capitalists may have had money in the company for several years as well. If insiders begin to sell a very large portion of their holdings, it should be viewed with concern, but not worried over. It would be difficult to view this as a vote of confidence, but it shouldn't cause too much alarm either.
Note: Insiders must file Form 4s when they sell, so the public investor can track this activity. If an insider owns 15% of a public company, selling 1% to 2% (especially if the price is doing well) is not usually a warning signal.
Factors to Determine the Impact of Ending Lock-ups
According to a study entitled, "The IPO Lock-Up Period: Implications for Market Efficiency And Downward Sloping Demand Curves" (New York University, 2000), at the end approximately 1,000 lock-ups in a sample analyzed by the Stern Business School at New York University, trading volumes of public companies permanently rose about 30% after lock-ups expired, while price dropped 1% to 3%.
One of the most critical factors in IPO lock-up selling is the average daily trading volume of the shares after the day of the IPO. If trading volume is very low compared to the number of shares in the lock-up, the price may well have more trouble holding up because there are few buyers in the market. An outside shareholder has much more to be concerned about if a company has 20 million shares in a lock-up and average daily volume of 10,000 shares than if the company's volume is a million shares a day.
Another sign of concern about lock-up selling is the short position in the stock right before the lock-up ends. Are short sellers betting that the stock will drop sharply as the lock-up period ends? The major exchanges all publish short data once a month and owners of IPO shares should watch these as lock-up periods end.
The Bottom Line
It is difficult to view sales by insiders as a positive move. On the other hand, founders and venture capitalists who have built a company can hardly be forced to hold shares indefinitely. Investors should keep a checklist that includes the percent of all shares that are locked up, average trading volume of the IPO company in the months between the offering and the expiration of the lock-up, board membership of insider shareholders that may limit their ability to sell, and the overall financial performance of the company and its stock. Even with insiders selling, shares in companies like Google have done very well.