What is a blocking agreement?
A freeze agreement is a contractual provision preventing insiders of a company from selling their shares for a specified period of time. They are commonly used as part of the initial public offering (IPO) process.
Although blocking agreements are not required by federal law, the underwriters will often require officers, venture capital (VC) companies and other insiders of the company to sign blocking agreements in order to d ” Avoid excessive selling pressure during the first months of trading after an IPO.
Key points to remember
- A freeze agreement temporarily prevents insiders of the company from selling shares following an IPO.
- It is used to protect investors from excessive selling pressures from insiders.
- Stock prices often fall after a blocking agreement expires. Depending on the fundamentals of the business, this can be an opportunity for new investors to buy at lower prices.
How blocking agreements work
Isolation periods generally last 180 days, but can sometimes be as short as 90 days or as long as a year. Sometimes all insiders will be “excluded” for the same period. In other cases, the agreement will have a phased lock structure in which different categories of insiders are locked for different periods. Although federal law does not require companies to use blocking periods, they may still be required by state blue sky laws.
Details of a company’s lock-up agreements are always disclosed in the prospectus documents for the company in question. These can be secured either by contacting the company’s investor relations department, or by using the Securities and Exchanges Commission (SEC) electronic data collection and analysis database (EDGAR).
The purpose of a freeze agreement is to prevent corporate insiders from dumping their shares from new investors in the weeks and months following an IPO. Some of these insiders may be the first investors, such as venture capitalists, who bought the business when it was worth significantly less than its IPO value. As a result, they may have a strong incentive to sell their shares and earn a profit on their initial investment.
Similarly, company directors and certain employees may have benefited from stock options as part of their employment contracts. As in the case of VCs, these employees may be tempted to exercise their options and sell their shares, since the company’s IPO price would almost certainly be much higher than the exercise price of their options.
From a regulatory point of view, blocking agreements aim to protect investors. The scenario that the freeze deal is supposed to avoid is an insider group taking an overvalued company on the stock market, then dumping it on investors while fleeing with the product. This is why some blue sky laws still have locks as a legal requirement, as this has been a real problem for several periods of market exuberance in the United States.
Even when a blocking agreement is in place, investors who are not company insiders can still be affected once this blocking agreement is entered into after its expiration date. At the expiration of the blockages, insiders of the company are authorized to sell their shares. If many insiders and venture capitalists are looking to withdraw, this can lead to a drastic fall in the stock price due to the huge increase in the supply of stock.
Of course, an investor can consider these two ways depending on his perception of the quality of the underlying business. The post-lock-up decline, if it does occur, can be an opportunity to buy stocks at a temporarily depressed price. On the other hand, this may be the first sign that the IPO was overvalued, signaling the start of a long-term decline.
Real example of a blocking agreement
Studies have shown that the expiration of a blocking agreement is usually followed by a period of abnormal returns. Unfortunately for investors, these abnormal returns are most often in the negative direction.
It is interesting to note that some of these studies have shown that staggered blocking deals can actually have a more negative impact on a stock than those with a single expiration date. This is surprising, as staggered lock deals are often seen as a downside solution after the lock.