An initial public offering, or IPO, is a rite of passage for a private corporation. It marks the distribution of the company’s ownership through the sale of publicly traded stock. Corporate insiders, employees and venture capitalists who owned private stock issued before the IPO may see a large gain in the value of their investments, but cashing in can take a while.
Private stock is typically ineligible for sale during a specific period of time following an IPO. This practice is commonly referred to as a "lockup agreement".
Exploring Private Stock
Before an IPO, a corporation can issue shares through “private placements.” These shares are not registered with the U.S. Securities and Exchange Commission. A private placement is a formal procedure in which the issuer must file certain information with the SEC and must adhere to strict rules governing who can buy the shares.
The shares are called “restricted,” because owners can’t sell them to the public without filing another request for a private placement. These shares carry a restrictive legend stamped on the back of the stock certificates. Under SEC Rule 144, restricted shares turn into publicly tradable ones after a holding period of six months. After the waiting period, owners receive reissued shares lacking the restrictive legend.
Understanding the Initial Public Offering
When a corporation decides to go public, it hires an investment bank to handle the sale of the new shares. The bank may decide to underwrite the IPO, which means it buys all the shares and then sells them through a syndicate of other banks and brokers.
If the investment bank is less optimistic about the demand for the new shares, it won’t buy them. Rather, it sells them on a “best efforts” basis. The syndicate receives a portion of the sale proceeds and the remainder fills the coffers of the issuing corporation.
Evaluating Lockup Agreements
An underwriter usually insists on a lockup agreement when it manages an IPO. The agreement prevents corporate insiders from selling their private stock for a set period following the IPO. The lockup period can vary but normally is 180 days.
During this time, owners of private stock must hold onto their shares. Some states require lockup agreements, and the SEC mandates that the issuer publicly disclose the terms of the lockup agreement. After the lockup period ends, corporate insiders can sell their shares to the public.
Other Relevant Considerations
If you're a buyer of newly issued stock, you face the risk of a price drop when the lockup period ends. If the value of private shares increases after the IPO, insiders may be eager to cash in as soon as allowed. This can cause a sudden increase in the supply of shares at the end of the lockup period, driving down prices.
You can find out whether a company has agreed to a lockup by contacting its shareholder relations department or by checking the stock prospectus. You can find the prospectus on the SEC’s online database – the Electronic Data-Gathering, Analysis and Retrieval system, better known as EDGAR.
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