What is Green Shoe Option in an IPO?

An initial public offering (IPO) is a process in which a private company first sells its shares to the public. Companies that offer an IPO can be brand-new, young businesses or established ones that have been operational for a while and have now decided to go public. 

Before investing in an IPO, investors read the company's prospectus – a document used by corporations to disclose mandatory information. The prospectus contains important information about the company and its IPO, like financials, objectives, and risk considerations. However, a lot of the minor details can be equally important.  

The greenshoe option is one of them, and it is regarded as one of the most important aspects of managing IPO demand. Continue reading to learn more about it. 

What is an IPO Greenshoe Option? 

Companies that intend to go public might use a legal process known as the greenshoe option to stabilize initial pricing. A greenshoe option permits underwriters to sell up to an additional 15% of shares than planned at the IPO selling price. It is also called an over-allotment option.  

If public demand surpasses predictions and the stock rises above the offering price, investment banks and underwriters who participate in the greenshoe process may choose to exercise this option. This means that when an investor’s demand for a security issuance turns out to be higher than anticipated, and the stock is trading above the offering price on the secondary market, the greenshoe option comes into play.  

On the other hand, the company does not exercise its option for additional shares if there is insufficient demand and the stock price drops below the offering price. 

The IPO underwriter is permitted to sell an extra allocation of the initial offering size, and this over-allocation of shares is used as a mechanism to boost a company's share price in the immediate aftermath of its IPO. For example, if a corporation issues 1 crore shares in an IPO and the over-allocation is determined at 15% of the offering, then there would be an extra 15 lakh shares.  

Process and Guidelines in Greenshoe Options 

Here are the process and guidelines for greenshoe options: 

After deciding to go public, the firm hires underwriters to find purchasers for their issuance. These underwriters may also assist the company in deciding the issue price and the type of equity dilution or how many shares will be made accessible to the public.  

However, given the fluctuating market conditions, it is highly possible that the IPO is undersubscribed and sells below its issue price. This is when these underwriters use the green shoe option to help stabilize the situation. 

The underwriter may execute the greenshoe share option within the first 30 days of the IPO date. 

The underwriter has the option to fully or partially exercise the greenshoe share option. This means that depending on how the price of the underlying stock changes about the offer price, the underwriter may purchase all or some of the shares from the company and sell those to its clients at a profit. 

Greenshoe Options Importance 

A company called "Green Shoe Manufacturing" exercised the greenshoe option, for the first time in 1918. It is now known as Stride Rite Corporation.  

Here are some of the important roles that greenshoe options play: 

Price Stabilization: Companies and underwriters primarily utilize the greenshoe option to maintain the company's share price after the IPO has closed. Let's say underwriters exercise the Greenshoe option to profit from the shares' popularity. However, the share price begins to decline following the listing. Thus, underwriters may repurchase those extra shares to maintain the share price. Once they purchase back, the number of shares available will drop, causing prices to rise. 

Buyback Shares at Offer Price: After the listing, it is quite likely that the company's share price will increase. If they repurchase the shares at market value in this situation, the underwriters will suffer a loss. However, they have the greenshoe option to buy more shares from the issuer company at the initial offer price. But in this scenario, underwriters won't experience any gain or loss. 

Extra Capital: If the demand for a firm's shares exceeds the supply, the greenshoe option benefits the business. The business will be able to raise 15% more money than it had originally anticipated, and it won't cost more. 

Greenshoe Options IPO in India 

The greenshoe option has also been made available in India in 2003 by the Securities and Exchanges Board of India (SEBI) to assist businesses in stabilizing their stock price.  

Some of the Indian companies, including Sahara Prime City, Lodha Developers, DB Realty, and Ambience chose the green shoe option, which assisted them in stabilizing share prices. 

Conclusion 

The greenshoe option lowers the risk for a firm issuing new shares by giving the underwriter the ability to cover short positions if the share price declines without taking the chance of having to purchase shares if the share price increases. As a result, both issuers and investors profit from the stability in share prices. 

FAQs 

Q. What is a brown shoe IPO? 

A brown shoe option is a technique used by underwriters to limit the volatility of the share price after the IPO. It allows the underwriter to sell a certain percentage of the shares issued at a greater price if the stock's market price falls.  

Q. What is IPO stabilization?  

Following an IPO, the price of freshly issued shares may be volatile or fluctuate trade. Underwriters will then purchase the stock to stabilize the secondary market price of the stock shortly after the IPO. 

Q. Is it necessary to exercise the green shoe option in a public issue? 

Under some conditions, such as when the issuer wishes to fund a specific project with a set amount and has no need for additional capital, some issuers decide not to include greenshoe options in their underwriting agreements.