Last Updated on October 19, 2023 by BFSLTeam BFSLTeam
The term Greenshoe options was first introduced in the United States in 1960 by an investment banking company named Green Shoe Manufacturing Company. This company was the first one to use this clause in its underwriting agreement.
SEBI introduced this Greenshoe Option or overallotment of share clause in India in 2003. With this option, underwriters and IPO issuers can ensure that their share prices stay stable after the initial share sale.
Read this blog till the end to know what is the Greenshoe option, its types, guidelines and benefits.
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What Is the Greenshoe Option in an IPO?
The Greenshoe option is also called the overallotment option. This is a provision in an IPO underwriting agreement which enables issuers to sell additional shares over an IPO or as a follow-on offering. The Greenshoe option works pretty much like a risk management system for an IPO issuing company.
This option clause looks into the overallotment of shares at the offer price in instances of high demand for shares. This option also lets an IPO issuing company buy back shares if there is an excessive supply. This is a necessary measure that companies take to avoid any major drop in their target share prices. Underwriters work to stabilise stock prices when they show signs of volatility.
Conversely, if share prices move up sharply, underwriters may execute a Greenshoe option to buy shares from an issuing company and sell them to their customers. This will help to meet excess demand and increase the stock’s market liquidity.
How Does a Greenshoe Option Work?
Now that you know about the meaning of Greenshoe option, let’s take a look at how it works.
With a Greenshoe option, underwriters involved in an IPO can support its market price upon launch, preventing it from falling. Underwriters can usually short up to 15% of the issuers’ shares. They do so in exchange for certain fees or commissions that the IPO issuing company must pay to underwriters as per their agreement.
If the share prices of this company fall, underwriters will become active and buy back these shares from the market and cover their short position. This decreases the supply of shares and its price increases due to buyback. It also increases the demand for shares among investors and ensures that the share price stays above its issue price.
Let’s assume a scenario where this share price increases. In such a situation, underwriters will buy 15% additional shares from the issuer at the offer price. This will help the underwriter to cover its position without incurring major losses.
As an investor, you will also stand to benefit from an IPO issue that executes a Greenshoe option. With it, you have some assurance of price stability post-listing. This facility is not available for an IPO without a Greenshoe option.
Additional read: Red Herring Prospectus
What Are the Guidelines for Greenshoe Options?
Here are a few guidelines that a company needs to abide by when exercising a Greenshoe Option.
- An IPO issuing company can only lend 15% of the entire offer amount.
- Companies can implement this Greenshoe option only within 30 days of its IPO date.
- Underwriters can execute this option in part or whole. This depends on the underlying stock’s price movement around its offer price. The underwriter can also acquire part or all of their allotted shares with a Greenshoe option.
What Are the Types of Greenshoe Options?
An underwriter can exercise three types of Greenshoe options. The points below will take you through the three types of Greenshoe options.
- Partial
As the name suggests, by implementing this Greenshoe option, underwriters can buy some shares from a single lot before the prices increase. At times of shortage, underwriters can approach the issuing company to buy back its remaining shares at the offer price.
- Full Greenshoe Option
With this option, underwriters buy 15% additional shares from the IPO issuing company. Underwriters can buy these shares at an offer price. They usually opt for the full Greenshoe option in case they are unable to buy back shares before the price rises.
- Reverse Greenshoe Option
Underwriters can use this option to sell additional shares back to the IPO issuing company after buying them from the market. They opt for this option when the demand for IPO falls or the prices become volatile.
How Greenshoe Options in IPOs Benefit Investors and Companies?
The points below highlight some essential benefits of a Greenshoe option in an IPO.
- To Cater to High Demand for an IPO
When demand for IPO shares is high among investors, underwriters can exercise the Greenshoe option. This happens when an established company goes public, reflecting high demand for its shares in the market.
- Helps with Price Stabilisation
After a company launches an IPO, underwriters check if the prices of already purchased IPO shares do not fall below its offer price. If this price falls, it reflects a decrease in market demand. This is harmful to a company’s reputation among investors in the long run.
It is here that underwriters come into play. They start buying a portion of IPO shares from a different bank account. This creates a shortage of shares and tends to increase demand owing to the Greenshoe clause of the underwriters’ agreement. With this measure, underwriters try to lower the chances of share prices from falling and maintain stability.
- Chances of Selling Prices to Go Above Offer Price
If the demand for IPO shares is high, the price of IPO shares will increase as well. In such a scenario, the company will suffer a loss if underwriters purchase the shares. Therefore, they can use the Greenshoe option and buy the additional shares at the initial offer price.
Also Read: Lock-In Period in IPOs
Summary
To conclude, the Greenshoe Option in IPO is beneficial for both investors and IPO issuers. This option saves investors from facing major losses owing to a decrease in share prices after buying them.
Like every equity investment, IPO investments also come with certain risks. Therefore, you should thoroughly read the DRHP and plan an informed investment strategy. If you are a novice investor, consider seeking guidance from a financial expert.
Frequently Asked Questions
The Greenshoe option offers retail investors an exit window for instances if they are not happy with the stocks’ volatility. This option also ensures investors that stock prices will be relatively stable.
The overallotment of shares gets its name from the company where it was used for the first time. This company is Green Shoe Manufacturing.
Underwriters can buy up to 15% of the additional shares at the offer price if demand for these shares tends to increase.
The Book-Running Lead Manager is the merchant bank that heads the underwriting process when a company plans to develop its DRHP for IPO.
