What is the Greenshoe Option?

It is a clause used during an IPO wherein the underwriters buy 15% of their shares at the offering priceOffering PriceOffering Price is the price that is decided by an investment banking underwriter when a company plans to go public list shares in the stock exchange for raising capital. This price is based on the future earning potential of the company, however, the price shouldn’t be too high then the shares might not be sold in full and if it is too low then the potential to raise more capital is lost.read more.

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How Does Greenshoe Option Work?

Greenshoe Option, coined after the firm named “Green Shoe Manufacturing ” (first to incorporate the greenshoe clause in its underwriter’s agreement). That is how it works: –

  • When a company wants to raise capital for some of its future developmental plans, it can raise money 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 (suppose 1 million securities at $5.00 each). In the case of a blue-chip company or a company with a very good background and  statisticsStatisticsStatistics is the science behind identifying, collecting, organizing and summarizing, analyzing, interpreting, and finally, presenting such data, either qualitative or quantitative, which helps make better and effective decisions with relevance.read more, demand for such security goes uncontrollably up. Due to this, prices will rise.Secondly, the existing subscriptions are way more than expected (e.g., 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 between the required and actual prices due to the unexpected demand for this security. To control this demand-supply gap, companies develop the “Greenshoe Option.”In this type of option, the company declares its strategy to exercise the greenshoe option during its proposal for IPO. Hence, it approaches a merchant bankerMerchant BankerMerchant Bank is a company that provides services like fundraising activities like IPOs, FPOs, loans, underwriting. They only deal with companies and businesses.read more in the market, who will act as a “stabilizing agent.”At the time of the issue of securities, the stabilizing agent borrows certain shares from promoters of the company to allow them additional subscribers in the market. In this way, the security price is not dramatically raised due to demand-supply inconsistency when the trading starts.The money raised from this additional market offering is not deposited in any party’s accounts. Instead, this money is deposited in an Escrow accountEscrow AccountThe escrow account is a temporary account held by a third party on behalf of two parties in a transaction. It reduces the risk of failing to oblige the transaction by either of the parties. It operates until a transaction is completed and all the conditions are met.read more 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, purchase back excess shares from the shareholders and repay the company’s promoters.The entire process of lending shares by promoters and repaying the same after a particular period by the stabilizing agent is called the “stabilizing mechanism.”

Features

  • The entire stabilizing mechanism must complete within 30 days. Therefore, the stabilizing agent has a maximum of 30 days from listing the company he needs to borrow and return the required shares for further process. If he cannot complete the process within this timeline and can return only part of the total shares to the promoters, the issuing company will allow the remaining shares to the promoters.Promoters can lend up to 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 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 the “Over-allotment Option.”Greenshoe option is price stabilization and is regulated and permitted by the SEC (Securities and Exchange Commission). Accordingly, if the company wishes to exercise this option in the future, it needs to mention all detailed red herring prospectusRed Herring ProspectusThe term “Red Herring prospectus” refers to the preliminary prospectus that a company files with the SEC in relation with its initial public offering. It contains information about the company’s operations but does not include details about the prices at which securities are issued or their numbers.read more it shall publish during the issue of securities.The stabilizing agents (or underwriters) must execute separate agreements with the company and the promoters, which mention all details about the price and quantities of the shares to be listed. It also says 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. It controls the shooting up of a company’s shares due to uncontrollable demand and aligns the demand-supply equation.This arrangement benefits the underwriters (who sometimes act as the stabilizing agents for the company). They borrow the shares from promoters at a special price and sell them higher to investors once they go up. When prices go down, they purchase shares from the market and return them to the promoters. It is how they earn profits.This mechanism is also beneficial to investors as it works to stabilize the prices, thus making it cleaner and transparent to investors and helping them make a better analysis.It is beneficial for the markets because they intend to correct the prices of the company’s securities in the market. Therefore, merely shooting up costs due to increased demand is an incorrect measure of the share’s prices. Hence, the company tries to direct the investors rightly by analyzing other things (rather than only demand) for the correct share prices.

Conclusion

The greenshoe option is based on its far-sighted vision, which foresees the increased demand for their stocks in the market. It also refers to their popularity among the general public and the investor’s faith in them to perform in the future and give them very good returns. This option benefits the company, underwriters, markets, investors, and the economy. However, the investors must read the offered documents before investing for optimum returns.

Greenshoe Option Video

This article is a guide to Greenshoe Option. Here, we discuss how the greenshoe option works, the role of underwriters, the process, and practical examples. You may learn more about investment banking from the following articles: –

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