A lock-up agreement is a legally binding contract between the underwriters and insiders of a company prohibiting these individuals from selling any shares of stock for a specified period of time. Lock-up periods typically last 180 days (six months) but can on occasion last for as little as 120 days or as long as 365 days (one year). Underwriters will have company executives, managers, employees, and venture capitalists sign lock-up agreements to encourage an element of stability in the stock's price in the first few months of trading.

Breaking Down Lock-Up Agreement

Lock-up agreements are a common component of initial public offerings (IPO) and may be required under certain states' blue sky laws. Investors only need to look in the prospectus to find out if a new offering has lock-up agreements with key insiders. There always will be a portion of shares that are traded immediately after the IPO, so the lock-up agreements do not prevent all post-IPO volatility. However, preventing insiders from selling keeps some blocks of stock in friendly hands, allowing price discovery to take place with fewer shares overall.

Why Lock-Up Agreements Matter to Investors

Lock-up agreements are meant to help protect investors. The scenario that the lock-up agreement is meant to avoid is a group of insiders taking an overvalued company public, then dumping it on investors while running away with the proceeds. This is why some blue sky laws still have lock-ups as a legal requirement, as this was a real issue during several periods of market exuberance in the United States.

Lock-Up Agreement Expiration and Stock Prices

Lock-up agreements also matter for investors because the term can have a price impact. When lock-ups expire, restricted people are permitted to sell their stock. If many of the insiders and venture capitalists are looking to exit, this can result in a drastic drop in share price due to the huge increase in supply of stock. Of course, an investor can look at this two ways depending on their perception of the quality of the underlying company. The post-lock-up drop (if it indeed happens) can be an opportunity to buy a new issue at a temporarily depressed price, or it can be the first sign that the IPO was overpriced and the start of a long-term decline.

Studies have shown that the expiration of the lock-up agreement coincides with a period of abnormal — to the negative side on average — returns for new issues. Interestingly enough, some of these studies found that staggered lock-up agreements with different expiry dates impact a stock more negatively than a single date. This is surprising, as staggered lock-up agreements are often seen as a solution to the post-lock-up dip.