Contract Locking: Everything You Need to Know
Contract locking is a clause or provision included in the contract terms created when a company decides to go public with an initial public offering (or IPO).3 min read
Contract locking refers to a lock-up agreement, which is a clause or provision included in the contract terms created when a company decides to go public with an initial public offering (or IPO). A contract is considered to be locked when specified activities occur, and a locked contract may not be modified by parties that do not hold the lock. This clause or provision is determined by the underwriters and insiders of the company.
The usual purpose of a lock-up agreement is to prohibit insiders from selling their company stake for a specified duration of time after the IPO closes. Some agreements do not prohibit the sale of shares, but instead limit the number of shares that may be sold within the specified period.
In some cases, the lock-up agreement terms may be included in the sale contract of the majority stake within a firm. The new buyer will be prohibited from reselling the stake or assets for a prescribed duration.
In most IPOs, contract locking is active from 120 to 365 days after the close. This prevents insiders from selling off their holdings opportunistically, which might occur as a result of insider knowledge of a company's overrated value.
Why Use a Lock-Up Agreement?
Lock-up agreements intend to protect a company's investors and prevent the possibility that a group of insiders take an overvalued company public, then leave it to the investors while they run away with the profits. Such an agreement may also be important for investors because the contract term can affect the stock's price.
Contract locking intends to stabilize the value of the stock for a certain duration of time. In addition, it ensures that insiders (associated with IPOs) and acquirers (associated with controlling stakes) behave in a way that supports the goals of the company. This allows time for the market to recognize the true value of the stock within a stable market. When selling controlling stakes, the acquirer may be required to agree to a lock-up clause prohibiting the sale of assets or stakes during the specified period, which is intended to stabilize the value for other stakeholders.
Immediately after the IPO, there will almost certainly be a portion of shares traded, so contract locking does not prevent post-IPO fluctuations. However, keeping insiders from selling their shares means that some chunks of stock will stay with friendly hands, which allows the discovery of the true value of the stock to occur with fewer shares overall.
A lock-up agreement ensures that IPO subscribers are not negatively affected by insiders. These regular subscribers may include:
- Venture capitalists.
- Family members of any of the above.
When is a Lock-Up Agreement Required?
Some states' blue-sky laws may require a lock-up agreement, as during a handful of periods of market exuberance in the U.S., this presented a very significant issue. To find out whether a new offering has lock-up agreements with important insiders, investors may look in the prospectus.
What Happens After the Lock-Up Period Ends?
Empirical data shows that the value of a stock often drops after the expiration period of a lock-up agreement. Any investor who intends to hold their shares or invest again in the firm after the initial public offering is closed needs to know when the lock-up period will end. Insiders are likely to sell part or all of their shares at this point, which will in turn generates market pressure to sell the company's stock.
Once the agreement's pre-determined duration of time is over, insiders are allowed to sell their shares, but may have to consider insider regulation laws, depending on the country.
It's possible that a contract underwriter may be concerned about the pre-IPO owners of a company knowing their stock is overvalued or participating in "window dressing" in order to make the company appear more profitable than it actually is. By prohibiting the sale of shares for a specified amount of time, the underwriter intends to allow the market to discover the true value of a company before the lock-up terms expire. This would discourage insiders from participating in opportunistic behavior (i.e. window dressing) before or during the IPO.
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