Greenshoe / Overallotment
Also referred to as the overallotment option, allows the underwriter to sell additional shares in the market if the demand for the securities exceeds the initially predicted demand.
What Is An Overallotment/Greenshoe Option?
The greenshoe option also referred to as the overallotment option, allows the underwriter to sell additional shares in the market if the demand for the securities exceeds the initially predicted demand.
It is called the greenshoe option because it was first used in 1919 by a Green Shoe manufacturing company, now known as Stride Rite.
This clause is incorporated in the underwriting agreement and gives the underwriter the right to sell more shares to stabilize the price of the securities in the market.
Under this clause, the underwriter may purchase up to 15% more company shares at the offering share price. Also, the underwriter must exercise the option within 30 days of the offering or the listing day of the share.
Suppose the prices of shares rise significantly due to the huge demand after the listing. In that case, the underwriting chosen by the issuing company will exercise the option and sell the additional shares in the market.
This will increase the supply of company shares in the market and stabilize the price.
In the United States, Security and Exchange Commission (SEC) regulates and permits the over-allotment option as the price stabilization mechanism.
Key Takeaways
- The greenshoe option, also known as the overallotment option, allows the underwriter to sell additional shares in the market if demand exceeds initial expectations, aiming to stabilize the securities' price.
- Incorporated in the underwriting agreement, the greenshoe option permits the underwriter to purchase up to 15% more company shares at the offering share price within 30 days of the offering.
- A Reverse Greenshoe clause permits underwriters to sell shares back to the issuer if share prices decline post-IPO. It acts as a put option, stabilizing prices by purchasing shares on the open market and selling them back to the issuer.
- If share prices trade below the offering price post-listing, it's perceived negatively. To counter this, underwriters take a short position on 15% of offered shares, repurchasing them post-listing to stabilize prices close to the offer price.
How a Greenshoe Option Works
When a company plans to sell its shares to the public, it selects an investment banking firm or syndicate to serve as the offering's underwriters.
Underwriters act as brokers for these shares, locating purchasers within their clientele. A price for the shares is established after a detailed analysis of their worth and projected value by the company after the consultation with the lead manager and underwriter.
The lead underwriter is empowered to assist the shares in trading at or above the offering price once trading in the shares starts on a public exchange.
If the public offering trades below its offering price, it may be perceived as an unstable or unsatisfactory offering, which may cause more selling and cautious share purchases.
To handle this issue, the underwriter takes a short position on 15% of the offering shares. Then, after the listing or offering of shares, the underwriter will repurchase these shares at or below the offer price.
The buying back of the securities helps stabilize the share price close to its offer price.
Note
During buyback, the underwriter is only covering or closing its short position, earning the margin between these two positions as the benefit.
When an issue is in significant demand, the price of the company shares rises and stays above the offering price.
Consequently, the underwriters would incur a loss if they decided to close out their short position by purchasing shares on the open market. Underwriters would have to pay more than they did when they initially sold the shares short.
The greenshoe (over-allotment) option would now be in effect. In addition, the green shoe clause grants the underwriter the right to buy up to 15% additional company shares than were originally issued at the offer price.
By exercising the option, the underwriters can end their short position by acquiring shares at the same price they shorted them for, preventing a loss.
Examples of Greenshoe Option
The greenshoe option is commonly included by businesses in their underwriting agreement. It helps in reducing the risk of the company raising capital by stabilizing the price of shares.
Some recent prominent real-world cases where the over-allotment option was utilized or would have been used by corporations during their initial public offering are:
Snap Inc. IPO
Snap Inc, the parent company of Snapchat, came with the IPO of 200mn shares at $17 in 2017. However, the IPO was oversubscribed by more than 10 times, meaning the investors wanted to purchase 10 times more than Snap intended to offer.
After the shares were offered to the public, underwriters exercised their full greenshoe option to purchase an additional 15% of originally offered shares at $17 minus the underwriter discount.
Robinhood IPO
In 2021, Robinhood, an online brokerage firm, filed for an initial public offering (IPO) for 55m shares apart from the greenshoe option at $38.
During the standard 30-day over-allotment period, Robinhood allowed its initial public offering underwriters to purchase up to 5.5m more Class A common stock shares at the IPO price, minus underwriting discounts and fees.
Robinhood's underwriters partially exercised their over-allotment option, purchasing 4,354,194 Class A common stock shares at the offer price of $38.00, minus underwriting discounts.
Facebook IPO
In 2012, Facebook (Now Meta) came with its IPO of 421mn shares at an offer price of $38. As its lead underwriter, Morgan Stanley sold 484mn shares, including the short position of 63mn shares.
The underwriters would have exercised the over-allotment option if the price of shares moved above the offer price. But almost soon after shares started trading, Facebook's price started to decline.
To stabilize the price and protect it from further declines, the underwriters closed their short position without employing the over-allotment option.
Reverse GreenShoe Option
A specific clause known as a "reverse greenshoe" in an IPO prospectus permits underwriters to sell shares back to the issuer.
If the share price declines in the post-IPO aftermarket, a reverse greenshoe is employed to support it. In this instance, the underwriter stabilizes the share price by purchasing shares on the open market and selling them back to the issuer.
Reverse overallotment acts as a put option, giving the underwriters the right to sell up to 15% more of the initial shares issued at the offer price if market prices fall below the offer price.
It differs from the regular over-allotment option, which serves as a call option and gives underwriters the right to purchase up to 15% more of the initial shares issued if market prices increase above the offer price.
For example, If a company came with a public issue of shares at the offer price of 30$ and gave the underwriters the put option or the reverse greenshoe option for the particular share amount.
If the share price falls below $30 after it starts trading on the stock exchange, the underwriters can buy the shares in the market and then exercise the option to sell those shares back to the issuer. This will help stabilize the share price close to the offer price.
Note
In some cases, a reverse greenshoe can stabilize prices more effectively than the regular greenshoe option approach.
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