The Role of Lockups in Initial Public Offerings

Abstract

In a sample of 2,794 initial public offerings (IPOs), we test three potential explanations for the existence of IPO lockups: lockups serve as (i) a signal of firm quality, (ii) a commitment device to alleviate moral hazard problems, or (iii) a mechanism for underwriters to extract additional compensation from the issuing firm. Our results support the commitment hypothesis. Insiders of firms that are associated with greater potential for moral hazard lockup their shares for a longer period of time. Insiders of firms that have experienced larger excess returns, are backed by venture capitalists, or go public with high-quality underwriters are more likely to be released from the lockup restrictions. An initial public offering (IPO) often represents the first opportunity that a firm’s founders and initial investors have to begin the process of realizing the value for their ownership stake in the firm. 1 We explore one particular aspect that regulates this cashing out by insiders, namely the structure of, the price reaction to, and the compliance with investment banker lockups, which restrict the ability of the firm’s management and prepublic investors from selling their stock in the aftermarket for a period of time after the IPO. Our article provides three contributions on going public and financial markets. First, we explore why prepublic insiders agree to long holding periods after the IPO. We test three potential explanations: (i) lockups as a signal of quality, (ii) as a commitment device to alleviate moral hazard problems, and (iii) as a means for investment banks to extract additional compensation from issuing firms. Our analysis supports the commitment hypothesis. Specifically, investment banks impose longer lockups when the moral hazard in the aftermarket is higher. We conduct several tests of the signaling hypothesis and find no support for the idea that insiders signal their “quality” by locking