It's a tough time to be a stock-rich employee at what have been some of the hottest young tech companies. Much of that money you thought you had has evaporated and drifted far away. Look at Facebook, with stock prices as low as half the initial IPO price.
It could be worse. Over at Groupon, some key early investors are bailing out as the market cap has dropped by three-quarters or more. Although they don't use the word "bubble," they might as well because they've clearly lost faith in the growth potential of their pet Internet companies. And then there's Zynga, where executives are being sued for alleged insider trading in a secondary offering not long before a bad earnings announcement.
There is at least one common factor in all of these examples: lock-ups. That is the practice of preventing employees and other insiders from selling their shares for an extended period of time after an IPO. The problem is that when the period is over, if there has been a lot of stock compensation, as is often true with tech companies, the sudden flood of additional shares can invoke the law of supply and demand and knock down the price.
Why Lock-ups Exist
In the cases of Facebook, Groupon, and Zynga, the end of a lock-up turned into another body blow to stock prices already challenged because of other factors. Surely these cases are proof that lock-ups are bad business, right? Wrong.
I recently spoke to Frank Slootman, CEO of ServiceNow, another recent tech IPO company, albeit in the business-to-business, not business-to-consumer, space. He made the interesting point that when a company initially starts trading publicly, no one really knows what the market will think the price should be. That's one big reason that investment banks demand lock-ups on insiders. If many more shares suddenly flooded the market too soon, the result would be plummeting stock prices that might become habitually low early on and never recover.
A company needs enough time to find its right price and then manage the potential wash of additional shares that could undermine the number. When done right, a company and investors get a relatively stable price.
The Real Issue
The problem with Facebook, Zynga, and Groupon is not the lock-ups. It is the fundamental weaknesses in the business models of those companies, which couldn't support the level of hype in which they indulged. Lock-ups have become an excuse for pundits and investors who bought into the buzz early on, despite common sense and a little financial analysis.
So, if you find yourself on a path to an IPO, do use lock-ups judiciously. And be sure to put your business plan through the wringer early and often.