IPO: What is lock-up period and how can it affect stock prices?
When a company offers its initial public offering (IPO), one may often come across the term ‘lock-in period’ or ‘lock-up period’. Lock-up periods generally apply to insiders, such as a company's founders, owners, managers, and employees. However, it is an important provision to understand even for the regular retail investor. Here is a closer look at this practice.
What is an IPO lock-up period?
A lock-up period is nothing more than a pre-determined timeframe in which, corporate insiders, investors, or employees, who have a holding in the company cannot redeem their shares immediately after an IPO. This happens when a company goes public and its shares are made available for sale to the public for the first time.
Market regulator SEBI requires promoters to have a contribution of not less than 20 per cent of the post-issue capital. Such contribution on the part of the promoters is locked in for 18 months. If the promoter's contribution in the share issue exceeds the minimum (20 per cent) requirement, that excess portion also needs to remain locked-in but only for six months.
What is its purpose?
The main purpose of having a lock-in requirement is simply to limit the volatility in the share price of the newly listed company when it debuts on the exchanges. The company insiders, promoters, and employees tend to own disproportionately high percentages of stock shares compared to the general public initially. The last thing a company wants post-IPO is for these extra shares to flood the market. Since share price is set by supply and demand, excess supply can easily drive down the price of the share and that is not good for a newly listed company.
Lock-up periods are a way for companies to keep up appearances. When investors see that those closest to the company hold their shares, it can signal that the investors have high confidence in the strength and growth prospects of the company. On the other hand, if insiders start dumping their own stock, it might spook retail investors, who may be prompted to sell their shares as well. A rapid fall in the share price can quickly change public perceptions and damage the company’s reputation. A lock-up period prevents this from happening, at least while the newly public company gets off its feet.
Investing consideration for the retail investor
It is recommended that retail investors should wait for the lock-up period to expire before investing in newly listed companies. While it might be tempting to invest in new stocks that keep going up during bull markets, one must remember that the market is not always favourable to IPOs.
At the end of the lock-up period, the stock price is bound to experience volatility as new shares enter the market and potentially results in a dip in stock price. Investors can then try to take advantage of the dip in price and may use the expiration of the lock-up period as a chance to buy shares at a discount.
Example – A good example of a lock-up period is Facebook. Post its IPO in May 2012, the lock-up period prevented the sale of 268 million shares of the company during the first three months. The company’s stock plummeted by almost 50 per cent to an all-time low of US$ 19.69 per share on the day the lock-up period ended.