A greenshoe option enables underwriters to increase the supply of stock to investors if an initial public offering (IPO) attracts higher than expected demand.
It is the only SEC-permitted measure that can be used to stabilize prices during the process. It’s a popular option because it reduces the risk for underwriters by offering greater flexibility during the IPO.
Types include a full or partial greenshoe, as well as a reverse greenshoe that allows the underwriter to take a short position on the stock. Although it’s most commonly used as part of an IPO, it can be used in secondary and follow-on offerings.
What is a greenshoe option?
A greenshoe option is a clause that is included in a share offering. It enables the underwriter, or their investment bank, to offer additional shares if the offering is more popular than expected. It is legally permitted by the Securities and Exchange Commission (SEC).
The term “greenshoe” comes from the name of the first company to implement this clause: the Green Shoe Manufacturing Company. They incorporated the clause in their 1919 IPO. The official name for this clause is an over-allotment option.
The goal of the over-allotment option is to ensure stable prices following an IPO. If the stock sells for the same price as it was offered at IPO, this indicates a successful offering. The company received optimal funding, the underwriter or syndicate group managed the pricing fairly, and investors did not initially lose money on their stock.
Minimal fluctuation in prices might be acceptable, but the greenshoe option exists to limit fluctuations and ensure a stable price
Typical options
In most cases, the greenshoe option allows for the sale of an additional 15% of shares. The option must be exercised within 30 days of the IPO. The exact details and allowances are highlighted in the underwriting agreement, and this will include specific conditions that must be met for the over-allotment option to be exercised.
Types of greenshoe options
- Full — The full greenshoe option is the standard over-allotment option. In this case, the greenshoe option is triggered if demand is higher than expected and the stock is trading higher than the IPO price. The underwriters can buy and sell 15% more shares at the initial price. This will bring prices back down, ideally to the same level as the offering price.
- Partial — It’s common for a greenshoe option to allow for the purchase of a further 15% of shares. However, the underwriter may not need to buy this many shares before prices are stabilized. A partial greenshoe option means that the underwriter bought a portion of, but not the whole, 15% before prices stabilized.
- Reverse — During a reverse greenshoe, the underwriter enters into a put option to buy shares from the market and sell them back to the issuer for a higher price. This type of option is used to support falling prices caused by reduced demand.
In summary, a greenshoe option can be incorporated into the underwriting agreement during an IPO to afford the underwriters some degree of control over prices. If the price of IPO stock on the secondary market is above the IPO price, the underwriter can sell up to an additional 15% of shares in a partial or full greenshoe option. Alternatively, a reverse greenshoe can be used to support falling prices.
