Unlocking the Mystery

With the tremendous volume of new issues, unlock dates are gaining prominence. So how should IROs handle them?

By now we're all used to reading the business press about the proverbial college senior with a dream and something marginally resembling a business plan scrawled on the back of a bar receipt. With the precipitous dip in dot-com fortunes, however, his vision of an internet site that caters to high-end buyers of utensils will never warrant an IPO or the post-graduation millions he anticipated.

At this point, given the demand investors have been making on dot-coms - for a moderate rationale for the company's potential future profitability - it's doubtful his virtual company would attract even a round of angel investors (mom and pop, in other words).

So the IPO pipeline clearly isn't what it was in 1999. Investors are left separating what has come to market into three neat piles: promising but overvalued; overvalued but with possibilities; and utterly hopeless, someone must be pulling my leg. But one byproduct of the lingering IPO fever continues to draw increasing attention: IPO lock-up agreements.

Under such an agreement, insiders agree not to sell their shares until a certain amount of time after the IPO. The actual time period determined by the lead underwriter usually runs 180 days from the offer date. These agreements are not a new phenomenon, but due to investors' enduring fascination with high-tech companies and the ancillary interest of the media, their expiration dates when the shares are effectively 'unlocked' have become more visible than ever.

The number of shares unlocking can be overwhelming. On March 21, 60.1 mn shares of free internet access provider NetZero were unlocked and one analyst cited this as a primary factor behind poor stock performance (its price slumped from close to $15 to $12.75 by April 10).

Net effect

Whether or not unlocking shares directly affects stock price is open to debate. A study by two professors at Penn State found a 40 percent increase in average trading volume, and a statistically prominent three-day abnormal return of -1.5 percent, at the expiry of lock-up periods. Meanwhile, a study of the 132 initial public stock offerings in the first half of 1999, conducted by Thomson Financial Investor Relations in New York, found that on average the expiration of a lock-up period had little effect on a stock's price.

The Penn State study, however, was based on a sample of 1,948 IPO lock-up agreements from 1988 through 1997, so it barely takes into account the late 1990s boom in technology stock valuations. The Thomson study is also open to criticism for its limited sample and for its focus on a short time frame during which demand for tech stocks was extremely high.

While the data may be ambiguous, most IROs who have weathered IPO lock-up periods regard the unlocking dates as mostly one-time events with implications for share price and volatility resulting on a case-by-case basis. For example, on April 20 over 20 mn shares of California-based E.piphany were freed following a 90-day follow-on lock-up agreement with lead underwriter Credit Suisse First Boston. (Follow-on and secondary offerings translate into new lock-up periods for insiders.)

The unlocking shares represented 64.5 percent of the company, but Todd Friedman, director of IR, says the date came and went without much fanfare. 'For us, volume was relatively low, although our lock-up ended after the big drop in technology shares, which may have discouraged people from selling.'

But even companies whose lock-up agreements ended during the run-up in prices last year witnessed only moderate trading abnormality and, in some cases, a bump in share price. When over 17 mn shares (just over 17 percent of shares outstanding) of Drugstore.com unlocked on January 23, the stock rose from $29.12, where it had closed the previous trading day, to $35. Meanwhile, volume increased nearly threefold. As of June, the stock was trading in the neighborhood of $6-7 a share.

'I think it's really hard to tell how the unlocks have affected us,' comments Judith McGarry, VP of strategic partnerships at Drugstore.com. 'There's been a sad but gentle movement downward in our price since February, but I would argue that has to do more with investors' opinions of B2C, rather than our shareholders' views on the company.'

Not for sale

The reality, says McGarry, is that despite being freed to sell shares, few shareholders end up exercising that option. 'Our employees believe in the long-term value of the company and don't want to sell. That's also true of our venture capital partners and our major shareholders.'

In fact, while hundreds of millions of shares become eligible for sale, shareholders face a host of restrictions. In addition, most major stockholders understand that massive selling will depress the stock price, while insiders know their actions can easily cause panic among investors who interpret their selling as rats leaving a sinking ship.

'The selling restrictions of Rule 144 apply to us in most instances, so we're not going to sell everything, but we tend to be long-term holders, so it's not an issue,' says Robert Goodman, a partner with Bessemer Venture Partners, one of the most active US venture capital firms focusing on high technology.

Perhaps statements like these explain why many professional investors give short shrift to unlocking dates. 'We're aware of the unlock dates, but they're not overriding factors for us. In terms of timing, with thinly traded stocks it could be a factor, but we really haven't seen much volatility based on the lock-up,' says Steven Tuen, portfolio manager of the New York-based Kinetics Internet Fund.

David Lee Manzler, who is the president of Equity Analysts in Cincinnati, Ohio, the advisor to the Analysts Internet Fund, agrees with this analysis. He notes that, at most, the expiration of shares may present temporary volatility. 'It's not something I see as causing a persistent downturn in the stock,' he says. 'If the company's good, the holders will keep their shares.'

So why was so much attention paid to unlocking shares in the case of NetZero? Not because selling stockholders dumped all 60 mn shares freed from lock-up. Certainly the number of shares spooked some investors, but the slide in NetZero coincided with the slide in most internet-related companies.

The more significant issue in NetZero's particular case was most likely the 1.5 mn shares insiders registered to sell in April. With an initial float of just 10 mn shares, the influx of 1.5 mn shares was sufficient to further fuel supply just at the point when the market's appetite for internet stocks was waning.

And of course, when insiders start selling their stock, investors tend to fret. 'The lock-up expiration is not going to be a factor for me,' assures Manzler. However he concedes that he does at least monitor trading activity at such times. 'I may wait to see what insiders do before making a decision,' he adds.

Dealing with the hype

The prospect of insider selling can combine with the possibility of excess supply hitting the market to create a kind of psychological cocktail. This can fuel a dangerous level of hype that can in turn induce stock volatility. To reduce the chance of this some companies and underwriters have begun staggering the dates on which lock-up agreements expire.

In its September 1, 1999 filing for a secondary offering, Silicon Valley's Juniper Networks listed six separate expiration dates, thus spreading and diminishing the impact of having all of its restricted shares unlocking at once after a 180-day period. 'Some investors really overreact when they see a lot of shares are releasing from lock-up,' says Randi Paikoff Feigin, director of IR for Juniper Networks. 'It's totally psychological, but it can be a problem. We thought that by staggering, we could bring shares to the market more slowly and gradually, and reduce the volatility and the irrational reactions associated with shares that are releasing from lock-up agreements.'

As for the nagging worry that unlock dates will prompt insiders to sell and push down prices, Feigin says that in Juniper's case, the price actually rose after the unlock date. 'I think people saw that insiders weren't registering to sell a significant portion of their ownership, and that gave them confidence in the company.'

Given the attention focused on insider activity, finding out who's going to sell and who's going to hold on to your shares may prove critical from an investor relations perspective. It is a task that presents varying degrees of difficulty, according to the particular characteristics of the company concerned, but is generally considerably easier now than in the past. 'Today, shares are much more concentrated in a few hands, which makes the process easier to manage,' explains Friedman. 'In the case of most young companies, the shares are concentrated mainly in the hands of founders and venture capitalists. When you can track down 75 percent of the shares with 20 phone calls, that's a big help. In E.piphany's case, we had a pretty good idea of what our largest shareholder's intentions were.'

By knowing what stockholders are planning to do with their unlocking shares, companies can work to mitigate the effects of excess supply hitting the market. This can be especially critical when the float is small, and even more critical when there is downward pressure on the stock. 'Once you've taken the pulse of your major holders, you make sure the market and the sellers are aware of what's happening,' says Friedman. 'If the shares do come to market, you've done some of the legwork so that people understand there is supply, and they can find buyers.'

Orderly distribution

So what do companies do when there are lots of holders looking to sell their unlocking shares? One of the most common tools to help ensure an orderly distribution of these shares is a secondary offering.

'We did a secondary offering to raise capital, but a classic motivator behind secondary offerings is to help with the orderly distribution of shares from selling stockholders,' says McGarry. 'If you have small float and you know people are planning to sell shares, their selling can create volatility. By having a secondary, you increase your denominator and reduce volatility, and you've got a chance to have long-term investors come in and buy the shares of selling stockholders.'

For Juniper Networks, a secondary offering allowed for an orderly distribution of shares from strategic corporate investors, such as Lucent and Nortel, which had invested early on in the company but had since moved more from being partners to competitors and wanted to sell. 'We decided to manage the distribution of those shares into the hands of institutional investors through a secondary offer. Basically, we acted as a liaison between selling shareholders and the market. We did another road trip and sought out investors who would hold on to the shares,' say Feigin.

The benefits of a secondary offering apply not only to the company, but also to selling stockholders and buyers, according to Feigin. 'For institutions, building a position if the float is small can be difficult,' he explains. 'With a secondary, they are able to acquire shares at a fixed price, which is a big advantage to the institution. It's also an advantage to us because the shares don't go to day traders where the outcome will be more volatile. Selling shareholders benefit by getting a fixed price for their shares as well.'

Ideally, stockholders would hold onto their shares (former strategic investors not withstanding) and unlock dates would come and go with barely a hint of abnormality. That's not the case, though it seems few actually sell as soon as their shares are freed from lock-up. For those who do want to sell, the unspoken rule is that a company's underwriters should step in and help find buyers.

'Our feeling is, typically unlock dates are one-time events. What happens depends on the nature of how large the lock-up is and who's selling. We've found that most don't sell. But typically,' confides one sell-side analyst, 'if there's going to be a lot of selling, the lead underwriter will start working with clients to manage the distribution of these shares.'

The Red Tape

While often spectacular amounts of stock suddenly released from lock-up agreements may cause panic among less knowledgeable investors, most shares are subject to various forms of selling restrictions, thus preventing the wide scale dumping of shares into the market. The most commonselling restriction derives from Rule 144 of the Securities Act. Under Rule 144, a person who has beneficially owned their shares for at least one year can resell the stock beginning 90 days after the date of the IPO prospectus. However, within any three-month period, the number of shares they can sell must be less than the average weekly trading volume during the four weeks before a notice of the sale is filed, and less than 1 percent of the total amount of common stock outstanding.

So who falls under Rule 144? That's where things can get a bit fuzzy. In addition to the selling restrictions covering restricted shares, Rule 144 also applies to shares held by affiliates of the company. 'The definition of affiliate is very non-specific. What's developed is a practitioner's rule of thumb, which is that all directors, executive officers, and 5 percent shareholders may be deemed to be affiliates, and should sell in compliance with Rule 144,' explains Ann Yvonne Walker, an attorney at Wilson Sonsini Goodrich & Rosati, Silicon Valley's biggest law firm.


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