Facebook: What to do after the "lock-up" expires

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(MoneyWatch) Thursday marked the first day that many Facebook (FB) insiders could sell their shares, which leads to the big question: Should they? And if you own shares, should you? Knowing what to expect when the so-called "lock-up" period ends after a company goes public can help with that decision. Indeed, the historical evidence on what usually occurs is pretty clear. 

Facebook shares ended the day at $19.87, a loss of more than 6 percent, and about half what they were selling for at the IPO in May.

An initial public offering is typically followed by a lock-up period of 90 to 180 days, during which some shareholders are restricted from selling shares. This is done to prevent the market from being completely flooded with company stock following its IPO, helping boost the share price by keeping stocks relatively scarce. Once that restriction ends, these insiders are free to trade their shares as if it was any other stock.

Should I sell when the lock-up expires?

The first consideration involves recognizing how much you have tied up in your company's success if you continue to hold large amounts of your employer's stock. If you're in that situation, you need to recognize that if your company's stock does well, the outlook would be brighter for pay increases, promotions, and more stock options or grants. On the other hand, if the stock does poorly, it increases the chance that your job will be put at risk at the same time your financial assets are taking a beating.

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Although the temptation may be strong to bet heavily on your company, you have to look at the other side of the equation and decide if the risk is worth it. Could you live with seeing everything you've worked for vanish if something happens to the company, or should you instead take money off the table and diversify your assets? Regular readers of this blog know how strongly I advocate diversifying all your assets (including your labor capital). This would mean selling shares so you don't hold a significant percent of your financial assets in your employer's stock (or any other individual company's stock, either).

Does the lock-up's expiration affect the stock price?

Of course, should you decide to sell, you also have to wonder what will happen to the price of your stock once these shares hit the market. Recent experience tells us to expect a drop on the first day of trading:

Basic logic tells you that share prices will drop once additional holdings are available. Other things being equal, increased supply puts downward pressure on prices. Thus, we might expect that on or around the lock-up expiration date, there would be a price drop that isn't expected to reverse. (The additional supply of shares isn't expected to be removed.)

By contrast, in a fully rational market such increases in supply should be anticipated. The increase in supply should be reflected in a company's stock price before the lock-up ends. In a 2001 study, researchers at Penn State University found that a lock-up lifting resulted in a roughly 40 percent permanent increase in average trading volume, along with an abnormal three-day return of -1.5 percent.

When selling shares, should I unload them all at once?

A natural question is to wonder if selling shares over time is the way to go. Perhaps you would be kicking yourself if you sold the bulk (or all) of your shares, only to see the price go up. However, the strategy to keep wealth once you've earned it is to diversify your risks. This is an important issue for employees and other pre-IPO investors who consider selling their stock once their lock-up agreement expires.

In a 2007 study that examined stocks' longer-term performance after an IPO, researchers at San Diego State University found that firms with an overvalued offering (relative to the estimated "true" value of the company) tend to experience more block trades right after the IPO. These stocks could be called "high sentiment" stocks (noise traders are influencing the setting of prices). Importantly, high block sales also generally indicate underperformance of stock price from lock-up expiration through the third year after the IPO.

Investors who need or want to liquidate large blocks of shares in a short time are at a disadvantage. Large sell orders often put downward pressure on stock prices -- what's referred to as "market impact." In addition, a large block of shares being offered may scare away uninformed investors. Such investors may rationally assume that the block seller has information that they, being less informed, lack. This adverse-selection effect contributes to the market impact of large block sales. However, this adverse selection effect may be smaller when large block sales are expected -- such as at the expiration of IPO lock-up periods.

One way to lessen the market impact of such a large trade is to break it up into several smaller trades. Many firms use sophisticated algorithms to place such trades, and each firm is a little different. While it's unlikely that any firm would disclose how it's done (as most, if not all, of these algorithms are proprietary), you can still ask about the possibility.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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