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Firms wishing to raise equity through IPO face a greater amount of uncertainty regarding their value. This uncertainty exists due to a large amount of information asymmetry between the issuers and investors of the securities. The insiders of the issuing firms know the real value of their firms. The investors on the other hand have very little information about the true value of issuing firms. This information asymmetry can result in adverse selection because investors are unable to distinguish between the low and high quality firms. The issuers, however, can

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reduce this information asymmetry by sending signals of their quality to the prospective investors. But for a signal to be credible, it should be costly and reliable. Moreover, a signal should be able to distinguish between the low and high quality firms (Arthurs et al., 2009).

Signalling theory remains an important component of the IPO research due to the information asymmetry between the insiders of issuing firms and potential outside investors at the time of issuing. The IPOs are susceptible to information asymmetry problem due to limited information available about the issuing firms prior to the IPO, no trading history and no news media coverage (Rao, 1993). Owners and managers of IPO firms possess inside and private information about the current and future cash flows and prospects of the firms which is not known to the outside investors. The issuing firms can reduce this information asymmetry by revealing the positive inside information through various signalling mechanisms. Previous research has identified certain signals which IPO firms may use to indicate their quality to the investors in an environment of high asymmetric information. Early studies, such as Leland and Pyle (1977), suggest that higher level of retained equity at the time of offering serves as a signal of quality. Models proposed by Welch (1989), Allen and Faulhaber (1989) and Chemmanur (1993) propose that high quality firms signal their quality by underpricing more at the time of IPO and these firms will be able to recoup the “money left on the table” in subsequent offerings. Similarly, certification by third parties has also been proposed as a signal of firm quality at the time of offering. Presence of reputed underwriters (Carter and Manaster, 1990, Carter et al., 1998, Dong et al., 2011), reputable accounting firm (Michaely and Shaw, 1995), VCs (Megginson and Weiss, 1991, Barry et al., 1990) and reputed VCs (Krishnan et al., 2011) have been found to be the quality certification signals in the earlier literature.

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An IPO lockup can also serve as a signalling mechanism to reveal the inherent quality of issuing firms to the potential investors. Arthurs et al. (2009) argue that for a signal to be beneficial, it must be visible and costly or difficult for others to mimic. Lockup as a signal of quality meets both of these criteria. The details about the lockup and expiry date of the lockup are clearly stated in the IPO prospectus. Sometimes, issuing firms particularly emphasise in the IPO prospectus that the lockups show the commitment of insiders to their business5. Moreover, lockups are costly because of non-diversification and illiquidity on part of insiders for a certain post IPO period. Only high quality firms with positive information about current and future prospects will be willing to bear the cost of being undiversified for a long period after the IPO. It will be difficult for the low quality firms to commit to a longer lockup as the true quality of the firm will be revealed in the aftermarket. A longer lockup is likely to hurt insiders of poor firms more than the insiders of a high quality firms. Lockup length may prove to be a better and credible signal than the retained ownership as in Leland and Pyle (1977). Insiders can signal quality by retaining a large equity at the time of IPO but they can sell the shares immediately after IPO if restrictions on insiders’ sales (lockups) are not in place. In that case, the signalling strategy may not be convincing to investors and the signal might not be effective in communicating the private information of insiders (Gale and Stiglitz, 1989). Courteau (1995) uses the length of holding period (lockup) as a signal of firm value. This commitment to holding period complements the signal provided by retained ownership. Insiders of firms can use lockup length to signal their quality. As lockups are costly signals, only the insiders of high quality firms will be willing to accept longer lock up periods (Brav and Gompers, 2003). Insiders in low quality firms will fear the discovery of true quality (through earnings announcements, regulatory filings, analyst scrutiny etc.) before they can

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cash out at the expiry of lockups and will not accept longer lockups (Brau et al., 2005). Brau et al. (2005) develop a formal signalling model for lockup length in which insiders of high quality firms’ signal “by putting and keeping (locking up) their money where their mouths are”. Longer lockups reduce information asymmetry and solve a pre-IPO adverse selection problem by signalling the quality of issuing firm.