Greenshoe Option in IPO: Types, Advantages and How it Works

An initial public offering (IPO) lets companies raise funds from the public in exchange for equity shares. After an IPO, the company’s shares are listed for the first time on stock exchanges.

During the IPO subscription period, market demand fluctuates, and the stock price may experience volatility after listing. To manage these situations, companies and underwriters use a mechanism called a greenshoe option.

This article explains what a greenshoe option in an IPO is, how it works, its types, implementation, and advantages.

What is a Greenshoe Option in an IPO?

The greenshoe option in an IPO is a provision that allows underwriters to sell additional shares up to 15% of the original issue size, subject to specific conditions.

This mechanism enables IPO underwriters to manage excess demand and support price stability after listing. When an IPO is oversubscribed, the green shoe option helps accommodate the additional demand, subject to offer terms and applicable regulations.

The greenshoe option operates for a defined period, usually 30 days from the listing date, and follows the applicable regulatory framework.

Example:

If a company offers 10 crore shares, an underwriter with a 15% greenshoe option may be permitted to sell an additional 1.5 crore shares. The implementation depends on the IPO structure and regulatory requirements.

Also Read: Types of Investors in IPO

How Does a Greenshoe Option Work?

The greenshoe option allows underwriters to sell more shares than the original issue size and manage their positions through market purchases or additional share allocations.

The process involves the following steps:

• Additional Share Allocation:

Underwriters sell additional shares to investors beyond the original offering size, creating an over-allotted position.

• Share Price Monitoring:

After listing, underwriters monitor the market price to determine whether stabilisation measures are necessary.

• Market Purchases:

If the share price falls below the offer price, underwriters may purchase shares in the market to cover their short position, subject to applicable rules.

• Additional Share Exercise:

If the price remains strong, underwriters may exercise the greenshoe option to obtain additional shares and cover their position, according to the offering terms.

Types of Greenshoe Options

The greenshoe options are divided into two types, as follows:

Naked Greenshoe Option

In a naked greenshoe option, underwriters sell shares that they do not own, creating a short position. They may be required to cover this position by buying shares in the market. This can initially increase the number of shares in the market, while further buying can influence market demand.

In certain markets, naked short positions may be restricted or prohibited. Therefore, investors should not assume that this arrangement is available in every IPO.

Covered Greenshoe Option

Under a covered greenshoe option, underwriters sell shares borrowed from the issuer or another party. This enables them to cover their short positions by buying shares from external sources, reducing the risk of creating excess supply in the market.

Also Read: What is IPO listing?

How is the Greenshoe Option Implemented in an IPO?

The greenshoe option is implemented through arrangements between the issuer, underwriters, and relevant shareholders.

The offer documents specify the applicable terms and conditions.

• Agreement and Disclosure:

The issuer and underwriters establish the over-allotment arrangement and disclose relevant details in the offer documents.

• Over-Allotment:

Underwriters allocate additional shares within the permitted limit, creating a position that can be covered through the greenshoe mechanism.

• Price Stabilisation:

Where permitted, underwriters purchase shares in the market to support the price and cover their short position.

• Option Exercise:

Underwriters exercise the option when appropriate under the offering terms, completing the additional share acquisition process.

Advantages of Greenshoe Option in an IPO

The greenshoe option offers several benefits to issuers, underwriters, and investors.

• Price Stabilisation:

It allows underwriters to purchase shares during periods of downward pressure, potentially reducing excessive post-listing volatility.

• Managing Oversubscription:

It helps underwriters address excess demand by permitting additional share allocation when the option is exercised.

• Improved Market Confidence:

A structured stabilisation mechanism may reassure investors that measures are available to manage short-term price fluctuations.

• Flexible Share Supply:

It allows the offering to accommodate additional demand within the prescribed limit and disclosed terms.

• Better Listing Management:

It provides underwriters with a defined mechanism to manage over-allotment positions and support orderly market trading.

FAQs

What are the types of greenshoe options?

Greenshoe options are divided into two types: naked greenshoe and covered greenshoe. In a naked greenshoe, underwriters sell shares they do not own to meet excess demand. In a covered greenshoe, underwriters sell shares they have borrowed from the issuer or another party.

What is the greenshoe option limit in India?

In India, SEBI sets the greenshoe option limit, which may vary depending on the specific regulations and guidelines. The maximum allowable limit ranges from 10% to 15%.

How long does the greenshoe option last after listing?

The greenshoe option stabilisation period is limited to 30 days from the listing date. After 30 days, the stabilising agent will stop intervening, and market supply and demand will drive the share price.