The greenshoe option, also known as the over-allotment option, is a financial provision used by companies during their initial public offerings (IPOs) to maintain stability in the stock price in the event of heightened demand for their shares post-IPO. It grants the underwriters, who facilitate the IPO, the right to issue additional shares, typically up to 15% of the original shares issued, if there is excess demand. The greenshoe option serves multiple purposes, such as preventing the share price from skyrocketing and providing underwriters with an opportunity to buy back shares at the offering price, thereby stabilising the stock price.
History of greenshoe option
The term "greenshoe option" is named after the first company to use this clause, Green Shoe manufacturing. The company went public in 1960 and employed the greenshoe option to stabilise its stock price. Over the years, the greenshoe option has evolved into a common feature in modern IPOs and plays a vital role in ensuring the success of the offering.
Types of greenshoe options
There are two primary types of greenshoe options:
- Naked greenshoe: In a naked greenshoe, the underwriters sell shares that they do not own. They create these additional shares to meet excess demand, thus increasing the supply in the market.
- Covered greenshoe: In a covered greenshoe, the underwriters sell shares that they have borrowed from the issuer or another party. This type allows the underwriters to cover their short position by acquiring shares from external sources, reducing the risk of creating excess shares in the market.
Guidelines for implementing greenshoe options
Implementing the greenshoe option in an IPO involves several key steps:
- Determine the need for a greenshoe option: The issuer and underwriters should assess the potential demand for the IPO and decide whether a greenshoe option is necessary to manage excess demand effectively.
- Incorporate the greenshoe option into the underwriting agreement: The issuer and underwriters should agree on the terms of the greenshoe option and include it in the underwriting agreement, ensuring transparency and legal compliance.
- Exercise the greenshoe option: If there is a surge in demand for the shares after the IPO, the underwriters can exercise the greenshoe option and issue additional shares, according to the predetermined terms and conditions.
The greenshoe option example
Let us delve deeper into the greenshoe option in action.
Example: XYZ corporation's IPO
Company: XYZ corporation is a technology startup that has gained significant attention in the market. It decides to go public through an IPO.
Offer details: XYZ corporation intends to issue an initial public offering (IPO) of 10 million shares at a price of Rs. 20 per share. The company is excited about the IPO, but it is unsure of how much demand there will be for its shares in the market.
Underwriter selection: XYZ corporation enters into an underwriting agreement with Investment Bank ABC. This agreement includes a greenshoe option, which is crucial for mitigating the uncertainty surrounding the IPO.
Greenshoe terms: The greenshoe option allows Investment Bank ABC to sell an additional 15% of shares, which amounts to 1.5 million shares, at the same Rs. 20 per share price. So, the maximum number of shares that can be issued under this arrangement is 11.5 million.
IPO process
- Initial offering
The IPO is launched, and the initial 10 million shares are offered to the public at Rs. 20 per share. The response is overwhelmingly positive, with investors eager to buy shares of XYZ corporation. This strong demand leads to a rapid increase in the share price.
- Decision to exercise greenshoe
Recognising the intense interest and demand for XYZ corporation's shares, Investment Bank ABC decides to exercise the greenshoe option. This means they are going to issue an additional 1.5 million shares, on top of the initial 10 million.
- Additional shares issued
Investment Bank ABC, as part of the greenshoe option, issues the extra 1.5 million shares to meet the increased demand. The price for these additional shares is still Rs. 20 per share, just like the initial offering.
- Benefiting the company
Crucially, the 1.5 million additional shares are purchased from XYZ corporation at the original offer price of Rs. 20 per share. This provides XYZ corporation with additional capital, giving them more funds to support their business growth and operations.
- Share price stabilisation
With the introduction of the extra shares into the market, the supply increases, which, in turn, can help stabilise the share price. In this case, the share price remains relatively steady at Rs. 25 per share due to strong demand. This benefits the investors who initially purchased the shares at Rs. 20 per share and offers a return on their investment.
- Covering short position
As per the greenshoe option, Investment Bank ABC initially borrowed 1.5 million shares from XYZ corporation to cover their short position. Now, with the shares issued through the greenshoe exercised, Investment Bank ABC can use these shares to cover their short position. This stabilises the share price further.
- Price support mechanism
Should the share price ever drop below the offer price of Rs. 20 per share, Investment Bank ABC can purchase shares from the market to cover its short position, effectively supporting the stock and preventing it from declining further.
Importance of greenshoe share options
The greenshoe option holds significant importance for various stakeholders involved in the IPO process, including:
- Companies: The greenshoe option allows companies to raise capital with confidence, knowing they have a mechanism in place to address increased demand. This increased confidence can lead to greater investor interest and participation in the offering.
- Underwriters: Underwriters use the greenshoe option to mitigate the risk of financial losses by buying back shares and stabilising the stock price in the face of excessive demand, making the offering more appealing to potential investors.
- Markets: The greenshoe option contributes to market stability by preventing excessive price volatility that can harm both issuers and investors.
- Investors: Investors benefit from a more stable stock price and greater confidence in the company, making it more attractive for investment.
- Economy: A successful IPO, aided by the greenshoe option, contributes to the overall health of the economy by promoting capital formation and encouraging investment.
Advantages of the greenshoe option
The greenshoe option provides several advantages, including:
- Price stabilisation: By issuing additional shares when there is excess demand, the greenshoe option helps stabilise the stock price, preventing extreme price fluctuations.
- Increased investor confidence: Knowing that a mechanism is in place to address increased demand boosts investor confidence in the IPO, leading to higher participation.
- Greater participation in the offering: With reduced risks of extreme price swings, the offering becomes more attractive to potential investors, resulting in more substantial participation.
Conclusion
The greenshoe option is a crucial tool for companies looking to go public through an IPO. It not only maintains stock price stability but also increases investor confidence, making the offering more appealing to potential investors. Ultimately, the greenshoe option benefits not only the company going public but also underwriters, the markets, investors, and the overall economy by contributing to a smoother and more successful IPO process. Understanding and effectively utilising the greenshoe option can be a strategic advantage for companies embarking on their IPO journey.
