What Is an IPO Lock-Up?
An initial public offering (IPO) lock-up is also referred to as a lock-up period. It is a contractual caveat outlining a period after a company has gone public when major shareholders are prohibited from selling their shares. Lock-up periods usually last between 90 to 180 days. Once the lock-up period ends, most trading restrictions are removed.
IPO Lock-Ups Explained
The purpose of an IPO lock-up is to prevent the flooding of the market with too much of a company's stock supply too quickly. Typically, only 20% of a company's outstanding shares are initially offered to the investing public. A single large shareholder trying to unload all of their holdings in the first week of trading could send the stock down to the detriment of all shareholders. Empirical evidence suggests that after the end of the lock-up period, stock prices experience a permanent drop of about 1% to 3%.
The Usefulness of Lock-Up Periods
IPO lock-up periods allow for the newly issued shares to stabilize without additional selling pressures from insiders. This cooling-off period allows for the market to price the shares according to natural supply and demand. Liquidity may be low initially, but it will eventually increase over time with the establishment of a trading range.
Option contracts may begin trading during the lock-up period, which further allows for stability and liquidity. The lock-up period also allows for up to two consecutive earnings report releases, which provide more clarity on the business operations and the outlook for investors.
As the lock-up expiration date nears, traders often anticipate a price drop due to the additional supply of shares that are available to the market. The anticipation of a price drop can result in an increase in short interest as traders short-sell stock into the expiration. Investors that are concerned about the upcoming lock-up expiration may try to collar or hedge their long positions with options.
While stocks tend to sell-off ahead of a lock-up expiration, they don't necessarily continue the selling pressure in all cases. If the pre-expiration sell-off is too dramatic, it can often cause a short squeeze on expiration day as short-sellers look to cover their shares with hopes to lock in profits or cut losses.
A short squeeze is often the case when a trade gets too crowded, and margin interest is exorbitant. Shares of Shake Shack Inc. triggered a short squeeze from the day before its first lock-up expiration on July 28, 2015, which catapulted the stock price over 30% in less than two weeks. The margin interest had risen to over 100% to borrow shares to short.