Thursday, December 21, 2006

IPO Stock Lockup Periods

I've been watching Jim Cramer's Mad Money TV show for a week now, and he keeps mentioning stock lockup periods which I knew nothing about and so searched the web to get the scoop. The most thorough explanation I found is this paper written by two professors from New York University's Stern School of Business. It's a 40-pager, and I haven't read it all yet, but here are the key bits filled in with details I gleaned from other parts of the web.

When a company goes public, typically a 15-20% stake is put up for sale to the public, with the remaining 80-85% still held by pre-IPO shareholders. Companies usually do not sell the shares directly to the public and instead retain the services of an investment bank that will underwrite the shares (i.e. agree to buy them from the company for a fixed price on a specified date), decide what the IPO price should be, and then sell the shares to the public on the open market. So the investment bank profits from the spread between the underwritten price and the IPO price. To successfully raise capital and profit from the spread, the investment bank must be able to generate demand for the IPO shares by judiciously setting the initial price and the initial supply of shares.

However, since pre-IPO shareholders own 80-85%, if they were allowed to sell at the IPO, the large selling or perception that large selling might occur would likely send the stock price lower immediately. That would not be good for raising capital or making money. To control for this risk, underwriters generally insist that pre-IPO shareholders agree not to sell their shares for a certain period of time -- the lockup period. There are no rules saying how long a lockup has to be, but most are 180 days from the date of the company's final IPO prospectus.

That stabilizes the supply of shares at the IPO, but what then happens when the lockup expires 180 days later? Those pre-IPO shareholders (except for insiders with further vesting periods) are now free to sell their shares on the open market! The extra supply of shares tends to cause a dip in the share price and increased trading volume. For detailed explanations why, you'll have to read the professors' 40-page paper. But the take-home point is that lockup expiration is linked to decreasing price with increasing volume and is something traders should be aware of when getting involved with stocks that IPO'ed less than 6 months ago. This is why Cramer keeps suggesting that you might want to wait until after the lockup period expires before buying certain stocks.

How do you know what stocks have their lockup period expiring? It's buried in the Forms S-1 and S-1/A filed with the SEC. For example, MA's lock-up agreement is here. But the easiest way is to visit EDGAROnline's IPO Lockup Period web page. It's possible to mess with the URL to look at lockup periods from the past, so you can see how often lockup expiration had an effect on price movement and volume for at least a few years worth of IPOs.


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