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April 12 2007| Filed Under IPOs, Short Selling, Stocks, Venture Capital
When companies "go public", the number of shares offered in the initial public
offering (IPO) is typically a relatively small portion of the overall
ownership. The balance of the shares is held by insiders, which include
management, founders and venture capitalists (VC) who funded the company while
it was private.
The exact number of shares that is offered in each IPO will differ from company
to company. For example, in 2004, Google offered 7% of its shares to the
public, while Vonage offered 20% of its shares to the public during its 2006
IPO. (To read more about IPOs, see What are the three phases of a completed
initial public offering (IPO) transformation process?, The Murky Waters Of The
IPO Market and IPO Basics Tutorial.)
Insiders Locked-Up
Although the number of shares offered will differ from one IPO to another,
nearly all IPOs have some sort of lock-up period. A lock-up period is a caveat
placed on insiders and pre-IPO holders that prevents them from selling their
shares for a set period of time after the company has gone public. A typical
lock-up period is four to six months.
There is no federal law or Securities and Exchange Commission requirement that
forces insiders or pre-IPO shareholders to be "locked up", but the investment
banks underwriting the IPO almost always request it so that insiders do not
flood the market with shares right after the company's initial public offering.
The lock-up in the prospectus (Form 424B4) is a contract between the insiders
and the purchasers of the IPO, so it is highly unlikely that it would be
violated.
This information is disclosed in the S-1 when the IPO documents are filed with
the SEC. The best sources for lock-up information are the SEC website and
several paid services including Edgar Online. The lock-up period will be
stipulated in the prospectus, called the S-1, but it is very important that
investors watch each revision of this document, called S-1As, because there
could be a change in the lock-up terms. (To read more about each form and
filing document see the SEC's list of Form Types.)
Watch: Initial Public Offering (IPO)
The Reason for Lock-ups
As a company goes public, underwriters want to be able to see what outside
investors believe the new entity is worth based on information like that found
on the balance sheet, the income statement (profits and losses) and executive
overviews of the business (business risks).
If inside investors are allowed to sell immediately at the time of the IPO, it
may well obscure the price that the markets put on the company by putting
selling pressure on the shares on the first day of trading.
The Positives of Insider Sales
The end of the lock-up period is as important as an earnings report or other
big event at a public company. There are several factors that investors should
watch for to determine whether post lock-up selling is a warning sign.
First, determine how long inside investors have had shares. Some founders may
have been with companies for several years, so the sales of their shares may be
the only way that they have to make significant money from their work. Both the
S-1 and proxy show terms of service for officers. (To find out more about
company management, see Evaluating A Company's Management and Putting
Management Under The Microscope.)
Another factor to consider is whether a venture capitalist has one of its
partners on the company's board of directors. If so, the VC firm may be less
likely to sell because of a concern that the board member could have inside
information about the company's activities. This also holds true for officers.
Quite often a lock-up period will end, but insiders cannot sell stock because
they have information on earnings or have access to other critical data that
the public shareholders do not.
Insiders are probably more likely to sell if a stock has gone up sharply since
the IPO. There is no hard data on this, but shareholders in a company with a
falling share price post-IPO do not want to add to investor concerns by selling
shares.
Remember, insider selling after a lock-up period is not necessarily bad. As
said above, often company management has worked for a number of years to build
the business, and its entire net worth is tied up in the value of the firm.
There is also the fact that venture capitalists may have had money in the
company for several years as well. If insiders begin to sell a very large
portion of their holdings, it should be viewed with concern, but not worried
over. It would be difficult to view this as a vote of confidence, but it
shouldn't cause too much alarm either.
Note: Insiders must file Form 4s when they sell, so the public investor can
track this activity. If an insider owns 15% of a public company, selling 1% to
2% (especially if the price is doing well) is not usually a warning signal.
Factors to Determine the Impact of Ending Lock-ups
According to a study entitled, "The IPO Lock-Up Period: Implications for Market
Efficiency And Downward Sloping Demand Curves" (New York University, 2000), at
the end approximately 1,000 lock-ups in a sample analyzed by the Stern Business
School at New York University, trading volumes of public companies permanently
rose about 30% after lock-ups expired, while price dropped 1% to 3%.
One of the most critical factors in IPO lock-up selling is the average daily
trading volume of the shares after the day of the IPO. If trading volume is
very low compared to the number of shares in the lock-up, the price may well
have more trouble holding up because there are few buyers in the market. An
outside shareholder has much more to be concerned about if a company has 20
million shares in a lock-up and average daily volume of 10,000 shares than if
the company's volume is a million shares a day.
Another sign of concern about lock-up selling is the short position in the
stock right before the lock-up ends. Are short sellers betting that the stock
will drop sharply as the lock-up period ends? The major exchanges all publish
short data once a month and owners of IPO shares should watch these as lock-up
periods end. (To learn more about shorting, see our Short Selling Tutorial and
When To Short A Stock.)
Conclusion
It is difficult to view sales by insiders as a positive move. On the other
hand, founders and venture capitalists who have built a company can hardly be
forced to hold shares indefinitely. Investors have to keep a checklist that
includes the percent of all shares that are locked up, average trading volume
of the IPO company in the months between the offering and the expiration of the
lock-up, board membership of insider shareholders that may limit their ability
to sell, and the overall financial performance of the company and its stock.
Even with insiders selling, shares in companies like Google have done very
well.
by Doug McIntyre
Douglas A. McIntyre is the editor of 24/7 Wall St., a financial commentary
site. He has been president of Switchboard.com, which was the 10th most visited
website in the world, and publisher of Financial World Magazine. He has served
on the board of TheStreet.com. McIntyre graduated from Harvard magna cum laude.