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IPO Lockups Really More Of A Suggestion

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One way to think about a share of stock is that it represents a portion of the ownership of a series of future cash flows from an entity actively engaged in business which generates revenues, and so it's worth the present value of those cash flows discounted at an appropriate rate. Another, also useful approach is to view a its as a pure token of supply and demand, so it's worth some number of dollars times the quantity of love or hate or indifference that people are currently feeling towards the name attached to it. A decent rule of thumb is that the more misspelled that name, the more you should rely on the pure-token theory.

If a share of stock is just a helpless plaything of supply and demand, then a good thing to do when selling it is to say "boy, I really wish I could hang on to this share of stock, but, y'know, [taxes /divorce settlement/pricey addiction]." This is especially true when you are the company issuing the stock, or a person intimately involved in that company, since such people are (1) often assumed to have some insight into the whole cash-flow thing that also maybe underpins stock prices and/or (2) often in possession of a lot of stock that might alter the supply/demand dynamics if it came loose.

Thus, in high-profile situations where companies and/or insiders sell lots of stock - like an IPO - they tend to sign lockups, where they commit not to sell any more shares of stock for a while, to prove that they love the stock dearly and are only selling out of dire financial necessity or to grow the business and scale and conquer the world and such. So investors know that, come what may, there will be no new supply coming from the inside for 90-180 days after the offering, which helps stabilize the supply & demand dynamic.

Except they don't know that at all. This is a nice article in the Journal pointing out that banks waive lockups all the time so they're kiiiiind of meaningless:

Wall Street underwriters increasingly are allowing corporate insiders to sidestep agreements that prevent them from quickly selling shares after initial public offerings. ... Under lockup pacts, underwriters bar company insiders from selling their shares, usually for 180 days after an IPO. The lockup restricts the supply of shares, helping buoy IPO prices; releasing more shares on the market can keep a lid on stock prices. ... This year, underwriters have allowed 10 such agreements to expire early, in some cases three months before the planned exit date. Since 2008, underwriters have allowed insiders at 11.4% of all IPOs to sell shares before lockup expirations, up from 6.2% in the previous five years, according to Dealogic, a financial-services data provider.

And while sometimes those waivers are harmless - stock is up post-IPO, company has released strong earnings, insider has unexpected divorce, etc. - some are of the less good, top-ticking-just-before-announcing-disastrous-earnings variety. Which understandably makes investors mad since the lockup was, after all, designed to limit the insiders' top-ticking opportunity to, um, the IPO itself.

So one thing you might wonder is: if squishy waiveable lockups like these are good, but not that good, wouldn't serious nonwaiveable lockups be better? Like: why sign a lockup contract with underwriters who are happy to release you to do another deal? Why not sign a lockup with someone who'll be a jerk about waiving it - ISS, say, or me?1 Or someone with incentives to keep the stock price up - the top 5 buyers in the IPO, maybe? Or just say in the prospectus "we commit to not selling any stock for the next 180 days, and if we do, go sue us for securities fraud." (I feel like that would work?)

Of course there's an answer, or sort of an answer:

Wall Street firms have other incentives to give the green light to management to sell early. The lead underwriters for secondary offerings before lockup expirations almost always are the same as the lead underwriters for the IPO, bankers say, leading to potentially lucrative underwriting fees. After the lockup expires, the underwriting business for a secondary deal is potentially up for grabs, they say.

That's phrased as "other incentives to waive the lockup," but it also means "other incentives to demand the lockup": if you are a bank, you always want the company to agree to a long lockup, and you always tell the company that investors demand it. But you're very, very conscious that a 180-day lockup guarantees you, not "no deal in the next 180 days," but rather "bookrunner fees on any deal done in the next 180 days."

One thing you might ponder is why all the things that are "necessary to get an IPO done" - greenshoes, lockups - are also potential financial windfalls for the underwriting investment banks. And I think there's a good answer! Banks are after all intermediaries between markets and issuers; they are supposed to use their repeat-player status and need to please investors to reassure those investors about the latest misspelled internet company they're bringing to market. If banks waived lockups every time insiders wanted to sell, and hurt the aftermarket trading of their offerings, then investors would get mad at them, refuse to trade with them in the secondary market, refuse to buy their IPOs, and quickly run them out of the lockup-waiving business entirely. Same if they screwed around with greenshoes too much. Underwriters rent their market reputation to issuers, and get paid for it in the form of (money and2) optionality like greenshoes and lockups. And then they play the delicate game of exploiting that optionality for financial gain, while not killing its long-term value through overuse.

Apparently there's been enough overuse for some investors to complain to the Journal, so perhaps you'll see fewer waivers in the near future. Or perhaps not: the industry is consolidated enough that investors and issuers may not have enough choice of IPO bank to complain too vocally, and the equilibrium may be shifting more towards exploiting the optionality. But if you're an issuer who doesn't need to rent bank reputation all that much, this might give you some reason to blaze your own path. I suspect Facebook - which paid barely anything at all for its underwriters' blessing - was a sexy enough IPO that it could have gotten done without any lockups; instead it had traditional lockups and then cratered. But when next it spoke of lockups it rolled its own: Mark Zuckerberg just announced he wouldn't sell more shares for a while, unless he changed his mind. That has basically the same effect as a regular, waiveable lockup, and worked similarly to boost the price. All it lacked was free optionality for Morgan Stanley.

Insiders Get Post-IPO Pass [WSJ]

1. I would totally do this. Anyone want to sign a lockup with Dealbreaker, we will publish it on the site, promise never to waive it, and publicly shame anyone who asks. There will be a small fee.

2. That's the simplest. These days anyone can, and some people do, sell stock without an underwriter: we have a whole internet, you can probably PayPal it. And yet an underwriter is pretty much a necessity to sell any meaningful amount of stock to people who actually, like, manage money for a living or otherwise pay attention. You pay the 7% or whatever to rent the reputation.