Greenshoe Option

What is the Greenshoe Option?

The Greenshoe option, also known as the over-allotment option, is a provision often included in an initial public offering (IPO) underwriting agreement. The underwriter can purchase additional shares from the issuing company at the offering price. The purpose of the Greenshoe option is to provide price stability in the secondary market by allowing the underwriter to sell more shares than initially offered if there is excess demand from investors.

In simpler terms, the Greenshoe option allows the underwriter to buy extra shares from the company at the IPO price, which can be used to meet high demand from investors and reach additional price stability if they rise significantly after the IPO. This option is typically exercised if the demand conditions warrant it, helping to ensure a smoother and more controlled trading process for the newly issued shares. It’s an important tool in the IPO fundraising process and is often the only method sanctioned by the Securities and Exchange Commission to stabilize fluctuating share prices during the initial days of trading.

The Origin of the Greenshoe

The term "Greenshoe" originates in the Green Shoe Manufacturing Company, now known as Stride Rite Corporation, founded in 1919. This company holds the distinction of being the first to incorporate the Greenshoe clause into their underwriting agreement. The Greenshoe option, also legally known as the "overallotment option," was aptly named because, in addition to the shares originally offered, it allows for additional shares to be set aside for underwriters.

The "overallotment option" or Greenshoe is significant because it is the only SEC-sanctioned method underwriters can employ to legally stabilize a new issue after the offering price has been determined. The SEC introduced this option to enhance the efficiency and competitiveness of the initial public offering (IPO) fundraising process to ensure a more controlled and stable trading environment for newly issued shares.

What are the types of greenshoe options?

1. Partial Greenshoe. This type of Greenshoe option is exercised when the underwriters are only able to buy back some of the shares before the share price starts to rise. In other words, they partially exercise the option by repurchasing a portion of the shares at the offering price. This helps maintain some price stability in the market.

2. Full Greenshoe. A full Greenshoe option comes into play when the underwriters are unable to buy back any shares before the share price begins to rise. In this case, the underwriter exercises the full option and buys shares at the offering price to meet the excess demand. This ensures price stability by preventing the share price from escalating too rapidly.

3. Reverse Greenshoe Option. While it has the same effect on share price as the regular Greenshoe option, the reverse Greenshoe option operates differently. Instead of buying shares from the issuer, the underwriter is allowed to purchase shares on the open market and then sell them back to the issuer. However, this can only occur if the share price falls below the offering price, making it a tool to mitigate the risk of price declines.

How do Greenshoe Options Operate?

1. Company Plans an IPO. Imagine a company plans to go public through an initial public offering (IPO). They intend to offer 10 million shares at an offer price of $20. However, they anticipate strong demand from potential investors.

2. Exercising the Greenshoe Option. The company includes a Greenshoe option in its underwriting agreement with an investment bank to account for potential excess demand. The Greenshoe option allows the underwriter to purchase an additional 1 million shares at the same offering price of $20 per share.

3. Strong Demand and Greenshoe Activation. As expected, demand for the IPO is exceptionally high, with orders from investors for 15 million shares. The underwriter exercises the Greenshoe option and buys an additional 1 million shares directly from the company at the offering price to meet this demand.

4. Price Stabilization. After the IPO, the stock price initially rises due to high demand but is then stabilized by the Greenshoe option. If the stock price falls below the offering price, the underwriter can purchase shares from the market and return them to the company, ensuring price stability.

Advantages of Greenshoe Options

1. Benefit to Underwriters. Underwriters, often stabilizing agents for the company, benefit from the Greenshoe option. They can borrow shares from promoters at a special price and sell them at a higher price to investors once the share prices increase. Conversely, when prices fall, they can purchase shares from the market at a lower price and return them to the promoters, thereby earning profits.

2. Investor Transparency. The Greenshoe mechanism is also advantageous for investors. It contributes to price stability, making the market cleaner and more transparent for investors. This stability allows investors to make more informed and accurate analyses of investment opportunities.

3. Market Correctness. The Greenshoe option benefits the overall market by preventing shares from skyrocketing due to excessive demand. It ensures that share prices are not solely influenced by demand but are also guided by other factors. This helps assess the correct and fair share prices, ultimately promoting market correctness.

4. The Opportunity to Stabilize Prices. The Greenshoe option plays a crucial role in price stabilization for the company, the broader market, and the economy as a whole. It effectively prevents the rapid and uncontrollable rise of a company’s share prices when there is an overwhelming demand. By doing so, it helps maintain a balance in the demand-supply equation.

Examples of Greenshoe Option

Example 1

Suppose an entity has a total issue of 1 million shares. In this arrangement, the relevant underwriters or stabilizing agents are granted the right to sell up to 150,000 shares to accommodate excess subscribers.

Example 2

In 2012, the soaring popularity of Facebook resulted in increased demand for the company’s shares. Capitalizing on this opportunity, the social media giant initiated its IPO. Under the Greenshoe provision, underwriters had the opportunity to raise additional funds by selling more shares. This demonstrates how the greenshoe option in IPOs benefitted both the company and the underwriters individually.