What is Greenshoe Option in IPO?

Suppose you are a novice in investing and come across an Initial Public Offering (IPO). In that case, you read the company’s offer document to study all the information about the company’s profile, competitive advantages, industry regulations, corporate structure, primary objectives, subsidiary data, risk factors, and a “greenshoe option.” 

Before we look into the greenshoe option, let’s understand a few basics about IPO. 

What is an IPO?

Before issuing an IPO, a company is considered to be private. A private company generates growth with the help of a small number of investors, including founders, friends, family and professional investors like venture capitalists. 

A company issues an IPO majorly to raise funds for its operations and generate more revenues. Before going public, the company must be ready for the Securities and Exchange Board of India (SEBI) regulations and the advantages and obligations of public shareholders. During this process, initially owned private shares are converted into public shares, bringing the value of the current private shareholders’ shares to the public trading price.

 A company’s IPO shares are valued through underwriting due diligence, and buying such shares contributes to its shareholder’s equity.

How does a company issue IPO?

When a company decides to go public, they begin the process by choosing an investment bank, also known as an underwriter. The underwriter acts like a broker between the issuing company and the public to sell its initial batch of shares. The underwriters then perform due diligence tasks such as preparing the document, filing, and marketing. 

Once the IPO is approved, the underwriter fixes the offering prices and the number of shares to be sold. The underwriter is responsible for offering analyst recommendations, post-market stabilisation, and building a market for the issue’s stock after releasing it to the public.

Introduction 

The greenshoe option, also known as the overallotment option, allows the underwriters to sell more shares (than the agreed number) during the initial public offering. Under this clause, the underwriter is permitted to sell up to 15% excess shares than the initially agreed number within 30 days of issuing an IPO. 

The IPO underwriting contract between the issuing company and the underwriters underlines the specifications of the allotment. If the shares have more significant interest and the sale price exceeds the offer price, the underwriters may exercise this option.

History of Greenshoe Option 

The 1919-founded Green Shoe Manufacturing Company (now known as Stride Rite Corporation) is the source of the term “greenshoe.” The company added the greenshoe clause in their underwriting agreement for the first time. 

The US SEC only allows such an option as a way for an underwriter to lawfully stabilise the price of newly issued shares after establishing the offering price. This option was made available by the SEC to improve the efficiency and transparency of the IPO fundraising market.

Why do we need the Greenshoe Option?

Price stabilisation for the business, the market, and the economy are made possible by this option. It balances the demand-supply relationship and prevents a company’s shares from skyrocketing due to excessive demand.

• High Demand

To benefit from the demand for a company’s shares, the underwriters may execute the greenshoe option. When a famous company decides to go public and issue IPO, it will attract public investors to invest just with their popularity. 

For instance, due to the popularity and potential of the company, Facebook’s shares were in high demand when it issued its IPO in 2012. The company was able to meet the demand by raising additional funds through the overallotment of its shares. 

• Price Stabilisation

When the demand for a company’s shares increases or decreases, overallotment can also be utilized as a price stabilisation tactic. The underwriters incur a loss when the share prices fall below the offer price, so they may purchase the shares at a lower price to keep them stable. 

Repurchasing shares increases the share price since it decreases the supply of shares. Say an underwriter exercises their overallotment option. They do it to help stabilise fluctuating, volatile share prices by balancing the supply and demand of the shares.

• Selling Price is More Than Offer Price

Share prices may rise above the offer price due to increasing demand for a company’s shares. In this case, the underwriters cannot repurchase the shares at the current market price since they would suffer a loss. 

However, such would not be the case if underwriters exercised this option and purchased additional shares at the initial offer price. The reason is that any loss sustained when the shares were trading below the offer price is balanced by the difference between the offer price and the current market price.

Guidelines and Regulatory Framework

The respective country’s market regulator determines these standards. 

Following are the key aspects of the legal framework for the green shoe option:

• The Securities Exchange Board of India (SEBI) in India frame the regulations.
• In India, the options window is 30 calendar days from the listing day
• , and the profits must be deposited with SEBI. The underwriters are not permitted to keep any profits gained through this option.
• The underwriters also help the company to decide the price and type of equity dilation or the number of shares to be made available to public investors.

The Facebook Example

In 2012, when Facebook went public, it sold 421 million firm shares to underwriters. These underwriters ensured that the shares were sold and the money raised was sent to the company. They received 1.1% of the transaction in exchange. Morgan Stanley headed up the underwriting. 

The first price of the Facebook stock when it began trading was $42, an increase of 11% from the IPO price. The stock’s price quickly dropped to $38 as it started to become volatile. The underwriters sold 484 million shares of Facebook in total, each for $38. The underwriters sold an additional 63 million shares (15%) in order to exercise this option. 

According to press reports, the underwriters intervened and bought more shares to keep the pricing stable. They repurchased the remaining 63 million shares for $38 each in order to make up for any losses suffered in maintaining the prices. 

Greenshoe option showed that the stabilising procedure could provide profits for underwriters of up to $100 million like earned by Morgan Stanley while stabilising the Facebook IPO.

Types 

There are three major types of greenshoe options, namely: full, partial, and reverse.

• Full

Under the full greenshoe option, the underwriter exercises their option to repurchase the entire 15% shares from the company. They can weigh in on this option when they are unable to buy back any shares from the market. The full buyback of shares allows them to cover their short sale position. By doing so, underwriters settle their account in the market with no profit or loss.

• Partial

When an underwriter implements a partial one, it implies that they can buy back a part of the 15% shares in the market. In this case, the underwriter experiences a shortage; hence, they approach the issuing company to buy the remaining shares at the offer price. The profits get limited in this scenario as the portion they buy back is at the offer price.

• Reverse

The reverse option is when the underwriter sells the extra shares back to the issuing company. They usually execute this option when the demand drops or to stabilise the price when it becomes volatile. In these scenarios, the underwriter purchases the shares and sells them back to the issuer at a higher price.

How does it help retail investors?

Most public investors have no clue about the impact of the overallotment of shares in the economy. The revenues generated from the exercising this option are used to secure the share of the issue price in case the market declines. The option increases the role of investment bankers enabling them to protect small investors by price stabilisation in case the market price falls below the offer price. 

In the event of volatile share price fluctuations, price stabilisation becomes a boon for small-scale and retail investors. They feel confident that the company’s stock won’t drop much below the offer price if the IPO documentation states that the firm has a greenshoe option agreement with its underwriter. As a result, one of the qualities that investors look for in an offer contract is a greenshoe share option. 

While also serving as a tool for additional revenue generation for the company, the overallotment of shares stops falling stock prices and saves the company’s reputation.

Conclusion

The greenshoe option is a versatile tool to stabilise fluctuations in the prices of newly listed stocks. The procedure also provides small or somewhat retail investors with certainty that they will have a secure exit option within the first 30 days following the listing of shares. 

Due to the investment banks’ engagement in stabilising prices, this exit would surely occur at a price close to the offer price. Enhancing investors’ confidence leads to better stock pricing, which the company requires. 

Undoubtedly, this option can help investors, companies, and regulators by protecting everyone from the significant price fluctuations of newly listed shares.

Frequently Asked Questions (FAQs)

Q. What happens if share prices fall?

The underwriters buy the additional shares to close out their short position. They repurchase the additional shares at a lower price and sell them at a higher price.

Q. What is the options window for an IPO?

The underwriter could only exercise this option within 30 days from the day IPO is issued.

Q. How does the greenshoe option help retail investors?

Price stabilisation benefits retail investors during volatile share price fluctuations. It also provides them with an exit window in case they are not comfortable with the volatile prices. If the IPO documentation says that the company has a greenshoe option agreement with its underwriter, such investors can be confident that the share price of the company will not fall far below the offer price.

Q. What is the reverse greenshoe option?

When the underwriter sells the additional shares back to the issuing business, it is known as the reverse greenshoe option. They typically exercise this option when demand declines or to maintain a stable price when it increases or decreases.

Q. How does the greenshoe option benefit the company?

The greenshoe option decreases the risk for a company offering new shares by letting the underwriter cover short positions if the share price falls without having to acquire shares if the price rises. As a result, the share price remains stable, benefiting issuing company.