Greenshoe option is the clause used in an underwriting agreement during an IPO wherein this provision provides a right to the underwriter to sell more shares to the investors than it was earlier planned by an issuer if demand is higher than expected for the security issued.
What is the Greenshoe Option?
How Does Greenshoe Option Work?
A Greenshoe Option, coined after the firm named Green Shoe Manufacturing (first to incorporate Greenshoe clause in its underwriter’s agreement).
This is how Greenshoe Options works:
- When a company wants to raise capital for some of its future developmental plans, one of the ways it can raise money is through an IPO.
- During an IPO, a company declares an issue price for its securities and announces a particular quantity of stocks it will issue (say 1 million securities at $5.00 each). In case of a blue chip company or a company with a very good background and statistics, it may so happen that, the demand for such security goes uncontrollably up, and due to which prices will rise.
- Secondly, since demand goes up the actual subscriptions are way more than that expected (say 500,000 actual vs 100,000 expected). In this case, the number of shares allotted to each subscriber comes down proportionately (2 numbers actual vs 10 expected).
- Thus there is a gap created between the required price and actual price, which is due to the unexpected nature of demand for this security. In order to control this demand-supply gap, companies come up with the “Greenshoe Option”.
- In this type of Option, the company, at the time of its proposal for IPO, declares its strategy to exercise the Greenshoe Option. Hence, it approaches a merchant banker in the market, who will act as a “Stabilizing Agent”.
- At the time of issue of securities, the Stabilizing Agent borrows certain shares from promoters of the company, in order to allow them to additional subscribers in the market. In this way, when the trading starts, the price of the security is not dramatically raised, due to demand-supply inconsistency.
- The money raised from this additional offering in the market is not deposited in any of the party’s accounts. This money is deposited in an escrow account created for this process.
- Once the trading starts in the market, this Stabilizing Agent can withdraw money deposited in the escrow account, as per requirement, and purchase back excess shares from the shareholders and repay to the promoters of the company.
- The entire process of lending shares by promoters and repay of the same after a particular time period by the Stabilizing Agent is called as the “Stabilizing Mechanism”.
Features of Greenshoe Option
- The entire stabilizing mechanism needs to be completed within 30 days. The Stabilizing Agent has a maximum of 30 days from the date of listing of the company within which he needs to borrow and return the required quantity of shares for further process. If he is unable to complete the process within this timeline and is able to return only part of the total shares to the promoters during this time, the issuing company will allow the remaining shares to the promoters.
- Promoters can lend up to a maximum of 15.0% of the total issue to the Stabilizing Agent. For example, if the total issue is supposed to be 1 million shares, promoters can lend the Stabilizing Agent only up to a maximum of 150,000 shares for allotment to excess subscribers.
- The first exercise of this option was made in 1918 by a firm named Green Shoe Manufacturing (now known as Stride Rite Corporation), and this option is also known as “Over-allotment Option”.
- Greenshoe option is a way to price stabilization, and is regulated and permitted by the SEC (Securities and Exchange Commission). If the company wishes to exercise the Greenshoe Option in future, it needs to clearly mention all intricate details in the Red Herring Prospectus it shall publish during the issue of securities.
- The Stabilizing Agents (or underwriters) need to execute separate agreements with the company and with the promoters which mention all details about the price and quantities of the shares to be listed. It also mentions deadlines for the Stabilizing Agents.
The significance of Exercising the Greenshoe Option
- The Greenshoe Option helps in Price stabilization for the company, market, and economy as a whole. It controls the shooting up of prices of a company’s shares due to uncontrollable demand and tries to align the demand-supply equation.
- This arrangement is beneficial to the underwriters (who sometimes act as the Stabilizing Agents for the company), in a way that they borrow the shares from promoters at a particular price, and sell them at a higher price to investors once the prices go up. Then, when the prices tend to go down, they purchase shares from the market and return them to the promoters. This is how they earn profits.
- This mechanism is beneficial to investors as well, as it works in a way to stabilize the prices, thus making it cleaner and transparent to investors and helps them to make the better analysis.
- Greenshoe option is beneficial for the markets because they intend to correct the prices of the company’s securities in the market. Merely shooting up of prices due to increase in demand is an incorrect measure of the shares prices. Hence, the company tries to direct the investors rightly by analyzing other things (rather than only demand) for the correct share prices.
The Greenshoe Option is based on the company’s far-sighted vision, which foresees the increased demand for their stocks in the market. It also refers to their popularity within the general public, and the investor faith in them to perform in the future, and give them very good returns. This type of Greenshoe option is beneficial to the company, underwriters, markets, investors and economy on the whole. However, it is the duty of the investors to read the offered documents before any kind of investment for optimum returns.
Greenshoe Option Video
This has been a guide to Greenshoe Options. Here we discuss how Greenshoe Option works in the price stabilization post the IPO, along with the role of underwriters, key features, process, and practical examples. You may learn more about Investment Banking from the following articles –