What is a greenshoe option?
Excess allocation is a greenshoe option. If the demand for a security issuance exceeds expectations, the underwriter might sell more shares than intended in an initial public offering (IPO).
A Greenshoe Option Works
In 1919, Green Shoe Manufacturing Company (now WWW as Stride Rite) introduced over-allotment options, known as greenshoe options. The underwriter can enhance supply and stabilize security issue prices via a greenshoe option. 1 The Securities and Exchange Commission (SEC) only allows this price-stabilizing strategy.
Greenshoe options allow underwriters to sell up to 15% more shares than the issuer’s initial quantity for 30 days following the IPO if demand warrants it. A greenshoe option allows the underwriters to issue 30 million more shares if a firm advises them to sell 200 million shares. As underwriters get commissions as a percentage of the IPO, they are incentivized to maximize it. Before an IPO, the issuing business files a prospectus with the SEC that explains the option’s proportions and terms.
There are two ways underwriters employ greenshoe options. Underwriters can acquire extra stock from the firm at a fixed price and issue it to customers at a profit if the IPO is successful and share prices rise. In case of a price drop, they purchase back shares from the market to cover their short position and stabilize the stock price.
In other cases, issuers choose not to include greenshoe options in their underwriting agreements, such as when funding a project with a set sum and no extra capital.
Sample Greenshoe Options
Facebook Inc.’s 2012 IPO, now Meta (META), was a famous greenshoe option. The Morgan Stanley (MS)-led underwriting syndicate agreed to buy 421 million Facebook shares for $38 each, less a 1.1% underwriting charge. The syndicate sold at least 484 million shares to customers, 15% more than the initial allotment, establishing a 63 million-share short position.
If Facebook shares had moved above the $38 IPO price soon after listing, the underwriting syndicate would have exercised the greenshoe option to acquire 63 million shares from Facebook at $38 to cover their short position and prevent repurchasing at a higher price.
The underwriting syndicate covered its short position without exercising the greenshoe option at $38 to stabilize the market and prevent further declines when Facebook’s shares fell below the IPO price immediately after trading began.
Conclusion
- An IPO greenshoe option is an over-allotment option.
- Green Shoe Manufacturing Company (now Wolverine World Wide, Inc.) introduced greenshoes.
- Greenshoe options commonly allow underwriters to sell 15% more shares than are issued.
- Greenshoe options offer price stability and liquidity.
- Greenshoe options enable short-term coverage without the risk of buying shares if prices climb.
