Lock-Up - Lake Wanaka, New Zealand

A lock-up prevents certain shareholders of a firm from selling their shares during and/ or after the placement of shares in the stock markets. Usually, lock-up requirements are part of the legal conditions for a public offering.

The general rationale behind lock-up provisions is to protect new shareholders for a certain period of time from potential losses caused by old shareholders unwinding their investments by selling large stock packages.

Such negative stock price reactions can economically be viewed as market participants’ interpretations of negative information about the value of the companies revealed by the potentially strategic behavior of the inside investors.

Empirical studies about stock price behavior around lock-up expiration dates have shown that in venture capital finance this problem is even more important for a number of possible reasons. First, because of the predominant role of informational asymmetries about project quality, the capital market learns about the company value only in the subsequent time after the initial public offering (IPO).

Additionally, venture capitalists are generally perceived as active investors, adding value to the companies beyond their capital contribution by means of their management knowhow, reputation, etc. Hence, if the venture capitalists leave too early, it may have negative consequences for the further development of the firm value.

Other possible sources of uncertainty about strategic behavior of investors in venture capital-backed companies with respect to the amount and time of their disinvestments in and after an IPO are, for example, tax considerations or the opportunity costs of nonredeployed cash, relative to alternative investment opportunities.

Investors in venture capital–backed firms, therefore, face the fundamental trade-off between selling their shares early at an underpriced value and waiting until the fundamental value of the firm is revealed.

In order to improve transparency and impose credible limitations to strategic behavior, lock-up clauses are often agreed upon as explicit covenants in financing contracts specifying different lock-up periods between the venture capitalist and other related insiders such as company founders, management, other investors, etc.