When a company goes public, insiders are often restricted from selling their ownership stakes for a certain amount of time called a “lockup period.” But when the restriction is lifted, share prices sometimes take a hit. Here’s what you need to know.
Back in late 2019, investors in Uber’s (UBER) initial public offering (IPO) received an unwelcome splash of cold water when the stock crumbled 17% over just a few days as the company approached the lifting of its “lockup” period.
“The lockup expiration certainly played a role in the sell-off,” said Dennis Hobein, senior analyst at research firm Briefing.com.
Does this mean investors should stay away from upcoming IPOs like home-sharing service Airbnb (ABNB) and food-delivery company DoorDash (DASH) until the lockup ends? Not necessarily. Though it’s definitely something to keep in mind, the lockup isn’t an automatic reason not to invest, either. Here’s what to know about lockups, how they affect stocks, and possible ways to navigate them as an investor.
Many companies compensate their teams with large stock awards, but they don’t want employees to sell large amounts of stock as soon as the company starts trading, so they use “lockup” periods—which typically last 90 to 180 days and prevent employees and other insiders from selling their stock when the company goes public. The stock can be much more volatile depending on lockup restrictions, and those aren’t always set in stone, either.
“Lockup periods are important for investors to monitor because the supply of stock available in the public market (known as the float) can increase significantly once insiders begin selling,” Hobein noted. “Unless an accompanying increase in demand meets this new supply, the stock price is likely to fall, at least in the near-term.”
Keep in mind, however, that a stock will typically react to the lockup period ahead of time. In other words, shares will often decline a few days or more prior to the expiration date as investors look to exit the stock before the new supply hits. That’s what might have happened with UBER (see figure 1 below).
Another 2019 example of a lockup-related drag was Beyond Meat (BYND), whose shares came under pressure after its IPO even though the company reported better-than-expected earnings and outlook. Some analysts said shares came under pressure because holders had started to worry about a possible burst of selling when the lockup ended. In this case and others, the mere fact that a lockup is out there, like a troll under a bridge, can be enough to spook investors.
Not all lockups work the same, either, which can cause more confusion. Fitbit (FIT), for instance, lifted lockup restrictions on two million shares early and announced an offering of 21 million additional shares not long after its IPO in 2015. The stock fell 10% in after-hours trading. It wasn’t a traditional lockup, in part because people didn’t expect the company to ask for an early lifting of some restrictions. You never know if the nifty IPO you’ve parked your money in might do something similar.
All these examples serve as reminders for investors to consider taking extra care ahead of anticipated IPOs toward the end of 2020.
The number of U.S. IPOs in 2020 spiked from 2019 despite COVID-19, according to Barron’s. The total may approach 200, which would top the tally from 2018—considered an incredibly strong IPO year. This year has seen the most money raised for U.S. IPOs since 2014.
DoorDash is considered by some on Wall Street to be the “hottest” near-term IPO. The company is already profitable, and had more than 543 million orders over nine months, according to its IPO filing. That was triple the level of a year earlier, and included 18 million users and 390,000 merchants. Of course this leaves the investor in the role of deciding what they think the future will hold and just as importantly what they are willing to pay.
Airbnb plans to target a range of around $30 billion to $33 billion, while DoorDash will seek a valuation of around $25 billion to $28 billion, The Wall Street Journal reported on November 29.
Another thing to keep in mind as all these potential new IPOs come down the pike is that sometimes there are multiple lockup periods for a single IPO. This is done so that the market isn’t flooded with a huge new supply of stock in a single trading session. Usually, multiple lockup periods are used for larger IPOs with a substantial amount of shares owned by executives.
Know what you’re getting into. Just because you think the lockup period is over doesn’t mean there isn’t another one waiting to potentially bite you later. Consider curling up with the company’s IPO prospectus before investing so you’re less likely to be surprised later.
That brings us to a key point. Before discussing ways to consider dealing with the lockup as an IPO investor, let’s note that IPOs, by definition, are packed with risk and might not be for everyone. Even for IPOs that have early success, the lockup period is a risk that most investors have to face when they dive into a newly-public company. That might have been a hard lesson for some BYND investors.
Before jumping into an IPO, consider learning some basics to help you avoid getting burned by a new offering. IPOs were once available mainly to institutional investors, but today many retail investors have the same opportunities to invest in newly public companies.
A lot of people, especially young investors, make the mistake of associating a product with the stock and park their money in newly public firms. Those who did in the past might have gotten burned.
“When it comes to IPOs, investors should consider keeping a cautious outlook,” said JJ Kinahan, chief market strategist at TD Ameritrade. “Many times in recent years, an IPO with a lot of publicity and hype sold off soon after its opening day.”
For those willing to venture gingerly into this volatile area of the market, however, there are potential ways to deal with the lockup. That doesn’t mean you can expect success, because nothing in the market is guaranteed. Still, here are some ideas that might help you navigate through the lockup period of your favorite new company.
First, while they are not for all investors and require prior approval to trade, some consider a role for options.
For instance, if you really loved BYND or UBER as a company and wanted to get into the stock early after the IPO, it might have been a risky idea to throw caution to the wind and simply buy shares. That would have left you unprotected if the stock crumbled approaching lockup. One alternative, with risks of its own, is to use the options market to try to help manage the risk of your investment.
Strategy #1: Long Put Options
One idea is to buy a protective put option. Long put options aren’t just for bearish traders. Buying puts can also be valuable if you’re bullish but wish to be cautious and look for a measure of short-term protection against an unforeseen drop in price—which, as we know, can happen around a lockup expiration.
Strategy #2: Options Collar
A potential idea if you’re interested in an IPO but know the lockup period is coming is to consider an options strategy known as a “collar.” Besides the stock you’re looking to protect, a collar consists of two options from the same expiration period: a long out of the money (OTM) put and a short OTM call. The idea behind the collar, rather than the long put by itself, is to allow the premium collected by selling the call to help pay for the cost of the put option.
Just as the put limits your risk should the stock price drop below your put strike, the short call caps your potential profit on the stock. Think of the put as a “floor” beneath your stock, and the call as a “ceiling.” Your choice of where you put the floor and ceiling determines the overall risk/return of your position. Of course the short call means your stock could be called away at any time until expiration, so for those interested in continuing to hold the stock into the future the risk of seeing the stock “called away” must be considered.
Strategy #3: Stop Order (aka “Stop-Loss” Order)
Here’s another potential strategy if you’re very confident that demand will be strong for an IPO and think the stock is likely to move higher over its first few trading days: You can buy the stock once it trades in the public markets and set a stop order to limit downside risk. A stop order is one that would sell the stock position if it drops to a certain price. It’s important to note that entering a stop-loss order does not guarantee execution at or near the trigger price. Once activated, the order competes with other incoming market orders.
“Knowing that a large lockup expiration looms, you’d then (hopefully) lock in profits after a few trading sessions and revisit the name after the lockup period expiration,” Hobein said. “Of course, it doesn’t always work out that cleanly and conditions would need to be favorable in the stock market for this strategy to be reasonably viable.”
Hobein called this a “more aggressive” IPO trading strategy. For those with less risk tolerance but who still want a bite at the IPO market, patience could be a virtue.
Strategy #4: Watch, Wait, and Move in Increments
Consider finding out how many shares will be unlocked at expiration. Not all lockup periods are equal. In fact, many times the lockup period has a fairly limited impact on the stock because the number of shares being freed up isn’t too substantial. Investors can find out how many shares will be involved in the lockup period by checking out the IPO prospectus.
“In the case of UBER, in which 1.7 billion shares were made available for sale, I believe many investors simply wait for the lockup period to expire before buying shares,” Hobein commented. “Once the dust settles, the stock typically stabilizes.”
Another possible way to try and deal with risks of large price movements with an IPO investment either before or after lockup is to consider buying shares in partial increments rather than going all in at once.
“People can be excited to invest in these companies, but it’s good to keep the potential downside in mind,” said Kinahan.
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