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May 31, 2001

How the VCs Did It

By Colleen Marie O'Connor

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When Gordon Hanka decided to study IPO lockups, he wasn't in it for the glory of a polished research paper published in April's Journal of Finance.

The assistant professor of finance at the Penn State Smeal School of Business was acting as an investor - curious and frustrated with the price dips that follow IPO lockup expiration dates.

In discussing his experience with a private investment that had eventually gone public and hit its lockup expiration, Hanka said he watched the company's stock price tumble 20 percent in approximately 15 minutes. "I assumed I was simply unlucky," he said.

Yet, after a year studying prospectus statements, trading statements and other SEC filings with fellow researcher Laura Casares Field, Hanka learned that his lack of luck was actually a systemic market regularity caused by an unlikely source.


In what may be the first report to investigate IPO share lockups, the study challenges the widely held view that company insiders will flood the market with sell orders at the lockup expiration and drive returns down.

Instead, it attributes the majority of the selling to venture capitalists. What's more, the research concludes that there is a predictable pattern of market behavior during this period, challenging some market paradigms.

"The Expiration of IPO Share Lockups" examined some 1,948 share lockup agreements from 1988 to 1997. The study found that aggressive selling by venture capitalists, not by company insiders, does more to affect return rates during the lockup period.

When lockups expire, researchers found a statically prominent three-day abnormal return of -1.5 percent. It also found a permanent 40 percent increase in average trading volume.

"The abnormal return and volume are much larger when the firm is financed by venture capital," the study noted.

"That's how they reap their gains. VCs are wealthy individual investors, some of whom have invested in these companies five years before the IPO. They are a large part of [some] deals," said Tom Frangione, portfolio manager at "So it's really no surprise. Lockups are watched extremely closely... and venture capitalists cash in."

The study found that venture-backed firms experienced a significant -2 percent abnormal return rate around the unlock day, while firms with non-venture corporate investors lost only -0.3 percent. Firms with no corporate investors gain a relatively insignificant 0.2 percent.

In the first year after the IPO, ownership by venture capitalists falls from 23 percent of total shares outstanding to 17 percent. In these same firms, ownership by executives falls only from 16 percent to 15 percent, while ownership by other corporate investors actually increases from 25 percent to 28 percent.

The study noted that these changes reflect both the changes in the holdings of the original, pre-IPO investors and the arrival of new investors.

"When shares are dumped, it does not seem to be from the usual suspects," said Hanka, co-author of the study.

"It's not the CEO, it's not insiders. Most of [the selling] seems to be done by VC investors. While this isn't a big shock, the extent that the effect of insiders was found to be unimportant was a surprise," he added. "This tells me [investors] need to look at these [deals] carefully before making trading decisions."

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