Greenshoe Option in IPOs- What Is It and How Does It Work?

The Securities and Exchange Board of India (SEBI) introduced the over-allotment of shares or the “Greenshoe Option” in 2003. This ensures stabilisation of share prices in the aftermarket of IPO issuance.

This clause receives its name from the first company to implement an overallotment of shares. Green Shoe Manufacturing Company was the first to use this clause in its underwriting agreement.

Keep reading for an elaborate idea about the Greenshoe option in IPO.

What Is the Greenshoe Option in IPOs?

The working of the Greenshoe option in IPO is quite like a risk management system. A company planning to go public issues an IPO following the general procedure. To do so, they seek assistance from investment bankers who work as underwriters and help these firms in finding investors.

The underwriting function contains a specific risk management clause called  the Greenshoe option. This clause covers the overallotment of shares at a offer price in case of excess demand or buying back shares from the public in case of excess supply to avoid any major harm to the company’s share price. When the share price is volatile, these underwriters work to stabilise the stock’s price.

How Does the Greenshoe Option Work?

The underwriter additionally shorts up to 15% of the issuer’s share. This is done in exchange for fees & commissions to be paid to the underwriter.

When the share prices of a company tend to fall, underwriters intervene in the market and buy shares and cover their short position As the supply of the shares decreases due to the buyback, its price increases. This action helps to protect against any significant loss and tries to stabilise share prices above their issue price..

However, if the prices of these shares shoot up, underwriters can exercise their Greenshoe power and buy additionally upto 15% of the shares from issuer at the offer price and cover their position without incurring a loss. .

Investors are likely to benefit from an IPO issue with the Greenshoe option. This is because they can get shares post-listing price stability as compared to an IPO without a green shoe option.

What are the Types of Greenshoe Options?

There are three types of Greenshoe options that an underwriter can exercise:

• Full 

In case of full Greenshoe option, underwriters repurchase the entire 15% of shares from the company. They opt for this option when they are unable to buy back any share before the share price rises. While exercising a full Greenshoe Option, underwriters can purchase these shares at offer prices. This results in a no-profit-no-loss for the underwriter.

• Partial 

When underwriters can only repurchase some shares out of the entire lot before their prices go up, it is a partial Greenshoe option. In such a scenario of scarcity, underwriters approach the issuing company to buy back its remaining shares at the offer price. 

• Reverse

When underwriters sell the additional shares back to the issuing company, a reverse Greenshoe option occurs. Underwriters execute this option when demand for IPO shares fall or their prices become volatile. 

What Is the Advantage of the Greenshoe Option?

• Agent of Price Stabilisation

After an IPO gets listed, the underwriter makes an attempt to ensure that the price of shares purchased does not fall below the offer price.. Falling below the offer price implies that the firm’s demand is declining in the market. This is bad for the company’s image. 

It is here that the stabilising function of underwriters comes into play. Underwriters start purchasing shares using a separate bank account. By purchasing these shares using the Greenshoe clause, underwriters try to mitigate the fall of share prices. The shares bought from the market are transferred to the the promoters.. 

• To Address High Demand

Underwriters can choose to exercise the Greenshoe option to take advantage of a company’s high demand in the share market. Unlike a startup, when an established company goes public, the demand for its shares increases among investors. 

• Selling Price Higher than Offer Price

Selling prices of shares can go above offer prices if the demand is high. In such cases, underwriters cannot purchase these shares or they would suffer losses. In these scenarios, these underwriters use the Greenshoe option and purchase the additional shares at the initial offer price. 

By doing so, they can balance any losses that a company incurs when investors purchase its shares below the offer price.

What Are the Guidelines for Greenshoe Option?

Here are certain guidelines a company needs to follow to exercise the Greenshoe option:

• Underwriters will only have a 30 days stabilization period to bring market stability after the listing of shares. This period ensues from the allotment date of shares.
• The underwriters are not permitted to keep the profits gained through this option with themselves as they have to deposit that money to SEBI.
• They must also assist firms to decide the pricing and quantum of equity shares that would be available for public investors. 

Final Word

Besides preserving the image of an issuing company, the Greenshoe option is also helpful for investors. When underwriters issue Greenshoe on a company’s IPO shares, it helps many investors against losing their money due to market volatility. 

Before investing in a company’s IPO, consider studying about them in their IPO prospectus. This will let you know if a company is capable of stabilizing its share prices following its IPO. 

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