Net Stocks Unchained

Get ready. The chains are coming off the Internet lockups.

Over the next five months, up to 236 million shares in newly public Internet companies, worth about $14 billion at current prices, will be freed from post-IPO trading restrictions. Each of these stocks, say buy-siders, could face a noticeable decline in its share price in the weeks leading up to the lock-up's end -- the moment when executives and other pre-IPO shareholders can start selling their holdings. These lockup expirations -- along with forthcoming Internet IPOs and secondary offerings by companies already on the market -- could slow the ascent of the Internet sector as a whole.

Lockup agreements are a standard feature of an IPO; early investors, including senior employees such as management and venture capitalists, promise the underwriter they will not sell their shares for a certain period after their company goes public. The expiration of the lockup period, which usually takes place six months after a company's shares start trading, adds to a stock's float -- the number of a company's shares outstanding that are freely tradable.

This month's lockup expiration on eBay (EBAY Quote), for example, could have a significant effect on the company's float. Last fall, after the company's IPO, 3.5 million shares became available for trading. But on Jan. 22, more than 24.5 million shares of eBay will be freed up for trading.

And, though the contention is subject to debate, the additional new shares from eBay and other companies could undercut one of the key supports of Internet-stock prices, says one buy-side tech analyst. "It's been the lack of floating stock that's been part of the fuel for the bubble," says Nick Moore, senior technical analyst at Jurika & Voyles. Too much demand and not enough supply.

At the very least, additional shares should reduce the huge volatility of Internet stocks, says Brian Salerno, a portfolio manager of the (MNNAX Quote)Munder NetNet fund. "Obviously, it increases supply," he says. "It should create more liquidity, which should mean that these things don't trade in such large ticks."

Looking at individual stocks, Moore and Salerno each say that downward pressure on stocks' prices occurs in anticipation of the lockup's end, not when the shares are actually freed up. "Right around 150 days or so, people start thinking about it," Salerno says. "When the lockup comes off and [insiders] start selling these things, I think the negative impact is already in these stocks, even though that's counterintuitive." Moore says he's played the lockup phenomenon in the past by waiting to buy a stock until it was in its lockup doldrums.

Over the past year, the lockup period has proved to be a cloudy crystal ball for predicting Net stocks' behavior. Shares in VeriSign (VRSN Quote), for example, fell 8% in the month before its lockup ended and continued to fall. DoubleClick (DCLK Quote) fell 9% and continued downward two more months. In the weeks preceding its lockup expiration, NetGravity (NETG Quote) suffered a precipitous drop in its stock price (see charts). Even so, its stock rose in the month before its 180-day lockup period ended.

In today's overheated market for Net stocks, news that insiders might be selling stock or that more shares might be available for trading don't necessarily scare off buyers. For example, shares in Beyond.com (BYND Quote), formerly known as software.net, rose 49% in the month leading up to Dec. 14, when its lockup expired. And when Network Solutions (NSOL Quote) said Monday that its controlling shareholder, Science Applications International, was selling 38% of its holdings in the company in a secondary offering, Network Solutions' shares rose 24 1/8 to 155 -- possibly in reaction to the simultaneous news that the company was splitting its stock.

Trying to figure out who will be affected by the unlock effect has "some subtleties," Moore says. Stock prices are most vulnerable when the newly freed stock is a large percentage of the earlier float, he says. Salerno also says it's worth looking at a stock's trading volume to see how many days it might take to absorb additional stock in the float. (The accompanying table lists Internet stocks with forthcoming lockup expirations, along with trading volume and stock information.)

Shares in eBay, which has a shorter-than-conventional 120-day lockup period ending later this month, may be hurt by the unlock effect. The company's stock fell 29% from 301 close on Dec. 22, but has since more than made up its losses. "eBay's going to do a real swan dive" as a result of the expiration, says Moore. (Jurika & Voyles isn't long or short in the stock.)

Of course, even when the lockup period expires, not all the freed-up shares can or will be traded. Executives with major holdings in their company are certainly aware that selling a huge block of their stock can be a public-relations disaster for their business. And Securities and Exchange Commission Rule 144 limits the amount of shares insiders can sell. Broadcast.com's (BCST Quote) prospectus, to use one example, explains that although 14.1 million shares will be freed up from the lockup, 10.7 million of those shares will be subject to Rule 144 insider-trading restrictions, which effectively prevent the top three shareholders from selling more than 1.5 million shares apiece every three months. At Broadcast.com, the two top executives own 7.5 million of the 14.1 million shares covered by the lockup. (Insider shares typically aren't counted as part of the float.)

Investment bankers try to minimize the impact of a large number of shares coming on the market by arranging block trades or setting up secondary public offerings through which the insiders can unload their holdings, says Dick Smith, senior managing director of equity capital markets at NationsBanc Montgomery.

The big question remaining is whether new shares coming on the market will satisfy investors' cravings for Internet stocks and ease the supply/demand imbalance for Net investments.

In addition to the lockup expirations, demand for more Net stocks may be satiated by the dozen-plus Internet-related IPOs already in the works, ranging from Internet service provider FlashNet Communications to Ziff-Davis' (ZD Quote) tracking stock for its ZDNet Internet operations. In addition, says Moore, other companies and their major shareholders will likely take advantage of market conditions to file for secondary offerings, following the examples of EarthLink (ELNK Quote), iMall (IMAL Quote), MindSpring (MSPG Quote), Inktomi (INKT Quote) and, most recently, VeriSign.

Supply "will come into play now" with Internet stocks, says Jay Shartsis, director of option trading at R.F. Lafferty. "It's been masked by the incredible strength in the group," he says.

But others don't agree. "If the markets continue the way they are, the supply will be mopped up very quickly," says David Braunschvig, managing director of Lazard Freres. He adds that he expects both individuals and companies to create a two-tier market, favoring large-cap companies like eBay or companies with an "economic logic" like Ticketmaster Online-CitySearch (TMCS Quote), among whose strengths he lists as its diversified revenues in e-commerce and advertising and an established brand in the offline world.

Ultimately the impact of lockup expirations may not be that great after all. "I think they bounce around like crazy anyway," NationsBanc's Smith says. "Assuming they're still in as great favor as they are now, at the end of the day when the smoke clears, they could be higher, not lower."

Internet Stock Lock-Up Expirations: A Look Ahead Company Lock-up Expiration Current Float Shares Subject to Lock-Up Days to Cover Additional Float* Broadcast.com 1/12/99 2.5 14.1 44.8 eBay 1/22/99 3.5 24.5 12.3 Cyberian Outpost 1/27/99 4.0 12.01 9.4 GeoCities 2/6/99 4.8 25.9 36.4 Digital River2 2/7/99 6.0 5.4 10.0 24/7 Media 2/9/99 3.3 11.7 37.5 Entrust Technologies 2/13/99 7.8 38.7 223.8 Inktomi3 2/17/99 9.9 9.7 12.7 Interactive Magic 4/22/99 4.0 2.3 28.3 EarthWeb 5/9/99 2.1 2.4 2.6 theglobe.com 5/11/99 3.1 1.1 1.3 Computer Literacy 5/18/99 3.0 38.44 118.9 Ticketmaster Online-CitySearch 5/31/99 7.0 20.4 34.0 uBid5 6/1/99 1.6 7.3 15.2 Internet America 6/7/99 2.3 3.1 6.5 AboveNet Comm's. 6/8/99 5.1 5.2 13.6 InfoSpace.com 6/13/99 5.0 14.0 38.4

*Assuming 3-month daily trading average as published by Market Guide. 1Includes 1.1 million warrants to buy stock. 2Had secondary 12/10/98; lock-up on additional 7.5 million shares expires 3/10/99. 3Numbers do not reflect proposed split. 4Includes 3.4 million shares eligible for sale 5/22/98 and 8.0 million shares the company intends to register when lockup expires. 5Stock will be distributed to shareholders in parent MALL.