Lock-up: an essential tool in the governance of companies accessing the capital markets
In the complex ecosystem of the capital markets, where perception and confidence are intangible assets whose value is difficult to quantify, the lock-up mechanism stands as a fundamental governance and safeguard tool for companies seeking admission to trading. Accordingly, when a company decides to go public or to bring in significant investors, it is customary to negotiate shareholding retention undertakings, among which the so-called lock-up clause is particularly prominent. Its purpose is generally aimed at protecting the private-to-public transition and providing certainty to investors.
In light of the foregoing, within the context of an initial public offering, lock-up agreements cannot be regarded as a mere contractual formality, but rather as a strategic decision with far-reaching implications for the company’s valuation, reputation and long-term stability. They therefore occupy a central position and constitute an essential element in the architecture of any transaction of this nature.
What is a lock-up: nature and function
A lock-up is a formal undertaking entered into by certain shareholders who, by reason of their position or any other criteria deemed relevant by the company or potential investors, are considered material to the structure and operation of the company. Under such undertaking, they agree not to sell, encumber or otherwise dispose of their shares for a specified period of time.
In essence, therefore, it is a contractual arrangement between the parties and does not derive from a constitutional obligation nor from a statutory or regulatory requirement. Nevertheless, depending on the characteristics of the public offering process, and whether on a voluntary basis or at the request of third parties, such undertakings may be incorporated into the prospectus and underwriting agreements, thereby forming part of the disclosure framework provided by the issuer to potential investors and, where applicable, to the competent supervisory authority.
As regards the function fulfilled by this type of undertaking, and notwithstanding the diversity of its practical implementation, it is closely linked to the security and protection intended to be afforded and demonstrated to potential investors and, more broadly, to other market participants, in relation to the company, its organisational structure and the retention of key talent.
Advantages and disadvantages of lock-up arrangements
Advantages
The establishment of a lock-up period in listed companies provides a series of strategic benefits that explain its frequent use in IPO processes, capital increases and transactions involving institutional investors, including the following:
- Retention instrument: The most evident positive effect lies in the usefulness of these undertakings in ensuring the continued shareholding and non-disposability of shares held by key persons in the context of corporate transactions of this type, thereby facilitating alignment, commitment and execution of the company’s strategic plan.
- Price stability at the commencement of trading: Limiting the supply of shares available on the market helps to reduce volatility, thereby stabilising the share price so that it more accurately reflects the long-term valuation the company seeks to convey.
- Transmission of confidence to the market: Subjecting founders, members of senior management or other personnel considered key to restrictions on the disposal of their own shareholdings constitutes a positive signal to potential investors.
Disadvantages
However, imposing restrictions on the disposal of shares also gives rise to certain adverse effects, beyond those that may be immediately apparent (e.g. operational costs or the temporary loss of liquidity for the affected shareholders), including the following:
- Risk of an “expiry effect”: Upon the expiry of the lock-up period, multiple transfers may occur simultaneously, potentially resulting in an oversupply of shares that may exert upward or downward pressure on the share price if the transition has not been adequately planned, structured and managed.
- Internal tensions: Ensuring the confidentiality of these agreements is of particular importance, as different terms will be agreed depending on the status and criteria applicable to the individual concerned, in order to avoid the emergence of internal conflicts that could adversely affect the company’s operations and reputation.
- Talent attraction issues: Careful drafting and structuring of such undertakings is essential, as they may otherwise act as a deterrent to the attraction and retention of talent.
Design and implementation of an effective lock-up
The structuring and implementation of a lock-up in listed companies requires a carefully coordinated approach in which legal, corporate and market considerations must be aligned to ensure its effectiveness. The following are the key elements for its proper articulation in practice:
- Alignment with the strategic objective: Prior to negotiation and subsequent drafting of the agreement, the purpose to be achieved by the lock-up periods must be clearly defined, taking into account the company’s business strategy and the individual subject to the lock-up.
- Definition of objective and subjective scope: At this stage, it is essential to identify the affected parties and the precise scope of the lock-up in terms of the instruments subject thereto, avoiding ambiguous wording that could give rise to disputes over interpretation.
- Temporal regime: Determination of both the duration of the lock-up and the specific dies a quo, depending on the professional profiles involved and the overall structure of the lock-up.
- Prohibited transactions and exceptions: Establishment of a numerus clausus, on the one hand, of prohibitions relating to transfers, the creation of security interests or any other form of disposal of the affected instruments, and, on the other hand, of exhaustively defined circumstances that constitute exceptions to the prohibition. Such exceptions may, however, be made conditional upon the assumption of the lock-up (or other pre-determined conditions) by the new holder of the shares.
- Compensation mechanisms and remedies: Inclusion of a penalty clause for breach, together with provisions for interim relief, clawback mechanisms, forfeiture of shares or other incentives, among other alternatives to be assessed depending on the company’s background and needs.
- Waiver and early release procedure: Definition of who may authorise early releases of instruments subject to a lock-up period and with what quorum, as well as the objective circumstances justifying the submission of a release request (e.g. a change of control or a regulatory error). This may be complemented by a schedule of “windows” or staggered sale arrangements to allow disposal of the affected instruments, thereby introducing flexibility into the lock-up period, increasing its attractiveness and mitigating price pressure upon expiry.
- Relationship with public documentation: Written provision for the parties’ commitment to incorporate the lock-up agreement into such public and private documents as may be required in order to comply with regulatory requirements, private obligations and/or the company’s strategic objectives.
Conclusions
Lock-up arrangements are a proven tool for providing certainty in market entry transactions and in processes involving the entry of strategic investors. Their effectiveness depends on a balanced design that combines sufficient protection for share placements and the strategic plan with proportionality, so as not to discourage those subject to the restrictions. Negotiation requires coordination between the finance function, the board of directors, legal advisers and underwriters, among others, all of whom must operate on the basis of a structured flotation plan. It is in this design, and its subsequent practical implementation, that the difference lies between a lock-up that adds value and one that becomes an impediment to governance and shareholder value creation.
If your company is considering a transaction of this nature, Devesa has extensive experience in the drafting, negotiation and implementation of bespoke lock-up arrangements tailored to concurrent needs, always in accordance with best market practice and applicable regulations, and with full legal and strategic assurance.
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