A greenshoe option is a provision in an initial public offering (IPO) underwriting agreement that grants the underwriter the right to sell more shares than originally planned if the demand for a security issue proves higher than expected. It is also called an over-allotment option.
Key Takeaways
- A greenshoe option is a provision in an IPO underwriting agreement that grants the underwriter the right to sell more shares than originally planned.
- It is also known as an over-allotment option.
- The greenshoe option was first utilized by the Green Shoe Manufacturing Company (now part of Wolverine World Wide, Inc.)
- Greenshoe options typically allow underwriters to sell up to 15% more shares than the original issue amount.
- They provide price stability, liquidity, and buying power to cover short positions if prices fall, without the risk of having to buy shares if the price rises.
How a Greenshoe Option Works
A greenshoe option provides additional price stability to a security issue because the underwriter can increase supply and smooth out price fluctuations. It is the only type of price stabilization measure permitted by the Securities and Exchange Commission (SEC).
Greenshoe options typically allow underwriters to sell up to 15% more shares than the original amount set by the issuer for up to 30 days after the IPO if demand conditions warrant such action. For example, if a company instructs the underwriters to sell 200 million shares, the underwriters can issue an additional 30 million shares by exercising a greenshoe option (200 million shares x 15%).
Since underwriters receive their commission as a percentage of the IPO, they have the incentive to make it as large as possible. The prospectus, which the issuing company files with the SEC before the IPO, details the actual percentage and conditions related to the option.
Over-allotment options are known as greenshoe options because Green Shoe Manufacturing Company (now part of Wolverine World Wide, Inc.) was the first to issue this type of option.
Underwriters use greenshoe options in one of two ways. First, if the IPO is a success and the share price surges, the underwriters exercise the option, buy the extra stock from the company at the predetermined price, and issue those shares, at a profit, to their clients. Conversely, if the price starts to fall, they buy back the shares from the market instead of the company to cover their short position, supporting the stock to stabilize its price.
Some issuers prefer not to include greenshoe options in their underwriting agreements under certain circumstances, such as if the issuer wants to fund a specific project with a fixed amount and has no requirement for additional capital. Underwriters can choose to either fully or partially exercise the option.
Real-Life Example of a Greenshoe Option
Meta, formerly known as Facebook, agreed to a greenshoe option when it listed its shares in 2012. The underwriting syndicate, led by Morgan Stanley, agreed with Facebook to purchase 421 million shares at $38 per share, less a 1.1% underwriting fee. However, the syndicate sold at least 484 million shares to clients—15% above the initial allocation, effectively creating a short position of 63 million shares.
If Meta’s shares had traded above the $38 IPO price shortly after listing, the syndicate would have exercised the greenshoe option to buy the 63 million shares from Meta at $38 to cover their short position and avoid repurchasing the shares at a higher market price.
However, since Meta’s shares declined below the IPO price soon after trading commenced, the syndicate covered its short position without exercising the greenshoe option, buying shares at or around $38 to stabilize the price and defend it from steeper declines.
Impact on Investors
Greenshoe options can essentially result in more shares being available for purchase at the IPO stage, opening the doors to more participants. They can also reduce initial share price volatility.
Origins of the Term ‘Greenshoe’
Over-allotment options are termed ‘greenshoes’ because the Green Shoe Manufacturing Company was the first to incorporate this clause in an underwriting agreement.
Types of Greenshoe Options
There are three main types of greenshoe options: full, partial, and reverse. With the full option, the underwriter sells the maximum amount of extra shares from the company. Under the partial option, they sell more than the originally agreed amount but less than the maximum permitted. With a reverse option, the underwriter sells the extra shares back to the company.
Maximum Capacity of a Greenshoe Option
Generally, the maximum amount of extra shares underwriters can sell is 15% more than the initially agreed-upon amount.
The Bottom Line
Greenshoe options provide underwriters the opportunity to sell more shares during an IPO, meeting high demand, and raising more capital for the company. They are a common mechanism in the U.S., typically allowing underwriters to sell up to 15% more shares at the agreed-upon IPO price within 30 days of the listing event.
Related Terms: Initial Public Offering (IPO), Underwriting Agreement, Liquidity, Commission, Short Position, Securities and Exchange Commission (SEC).
References
- Ross Geddes. “IPOs and Equity Offerings”, Page 206. Elsevier Science, 2003.
- U.S. Securities and Exchange Commission. “Frequently Asked Questions About Regulation M”, Select, Q: Is the exercise of the overallotment option considered a syndicate covering transaction?
- Harvard Law School Forum on Corporate Governance. “Underwriters Do Not Use Green Shoe Options to Profit from IPO Stock Pops”.
- CNBC. “How Banks Cash In On Flailing Facebook Shares – Accidentally”.
- U.S. Securities & Exchange Commission. “Facebook, Inc., Form S-1, As filed With the Securities and Exchange Commission on May 16, 2012”, Summary Page.
