Definition of lock-up agreement
Underwriters in IPOs and insiders of the issuing company agree on lock-ups to prevent the insiders from selling their stock within a given time window after the IPO. This time window normally amounts to 180 days.
The lock-up agreement attempts to ensure the stability of the issuing company and to align insiders' incentives with the goals of the company. After the expiration of the lock-up period, insiders are free to sell, but potentially have to take into account insider regulation prevalent in many countries.
Empirical evidence shows that the expiration of the lock-up agreements is often associated with negative stock returns for the company's stock.
An underwriter might, for example, be concerned that the pre-IPO owners of a firm may know that their firm is overvalued or even engaged in window dressing to let the firm appear as profitable as possible.
By restricting their stock sales for a certain period of time, the underwriter hopes that markets use this time before the lock-up expiration to figure out the true value of a company. Insiders could thus be deterred from engaging in opportunistic behaviour before or at the IPO.