If you have just started to invest, or have stayed away from buying shares in newly-listed companies, you might not know what a lock-up period means. Fear not though, now you will be in the know when and if you see your stocks' prices move after their lock-up session ends. 

So, without further ado...

... what is a Lock-Up Period?

A lock-up period is a certain amount of time when insider investors and employees who retain stock options are prohibited from selling shares in a particular company. Companies who have just listed their shares on the stock exchange generally use lock-up periods to stop management and stockholders of a publicly-traded company from selling their shares immediately following an initial public offering (IPO).

Companies do not have to use a lock-up period but if they do, they must underwrite it in the IPO request. 

Advantages of a lock-up period: 

• The main benefit of a lock-up period is it prevents extreme volatility on IPO day by ensuring employees and insiders don't flood the market when they sell their shares, which lowers the stock price. When a stock makes its debut, it's normal for its share prices to jump up and down but at least with a lock-up period, insiders are prevented from selling their shares so volatility is reduced significantly.
• A lock-up session allows the market to determine the stock's true value instead of a share price solely falling due to insider selling. By giving a stock the time to settle down into its fundamentals its real price will be found, reflected by how the market determines the company's potential.
• If lots of shareholders close to the company, such as upper management or early investors, sell the stock just after its IPOs, it also looks bad as it shows a lack of faith in the business.
• Another advantage is that it allows these firms to retain more cash to use to grow their businesses, as it is not all sold off on day one.

How long does a lock-up period last?

A lock-up period tends to be between 90 and 180 days. On one hand, investors and employees want a shorter period so they can cash in their shares earlier. Whereas on the other, underwriting banks hope for longer lock-ups so the share price doesn't fall dramatically when insiders sell their shares. Therefore, a company tries to find a nice balance between the two to ensure investors are happy and have faith in the stock whilst also keeping banks content. 

Even after a lock-up period expires some insiders still can't sell their shares because they have obtained private information about the company which would make the sale insider trading. 

Do long-term investors need to worry about lock-up periods? 

In the grand scheme of things, they don't really. While a big sell-off might highlight that those close to the company don't believe in the stock anymore, it could also be as simple as shareholders wanting to cash in their profits on a well-performing stock. 

Let's look at an example. 

All the way back in 2010, 180 days after Tesla's IPO, shares fell 15.1% in one day when insiders were given the option to sell. The sell-off even began the day prior as investors anticipated a big move, with shares falling 7.8%. You should note that Tesla stock is up over 18,000% since its public market debut so I bet those investors regretted selling.

We always recommended investors to know about these actions in case you become alarmed if your stocks fall all of a sudden. This can all be avoided by being aware that after a certain amount of time following a company's IPO, when the lock-up period ends, a stock will most likely experience some volatility.

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MyWallSt operates a full disclosure policy. MyWallSt staff currently holds long positions in companies mentioned above. Read our full disclosure policy here.