Companies that want to venture out and start selling their shares to the public have ways to stabilize their initial share prices. One of these ways is through a legal mechanism called the greenshoe option. A greenshoe is a clause contained in the underwriting agreement of an initial public offering (IPO) that allows underwriters to buy up to an additional 15% of company shares at the offering price. The investment banks and brokerage agencies (the underwriters) that take part in the greenshoe process have the ability to exercise this option if public demand for the shares exceeds expectations and the stock trades above the offering price. (Read more about IPO ownership in IPO Lock-Ups Stop Insider Selling.)

The Origin of the Greenshoe
The term "greenshoe" came from the Green Shoe Manufacturing Company (now called Stride Rite Corporation), founded in 1919. It was the first company to implement the greenshoe clause into their underwriting agreement.

In a company prospectus, the legal term for the greenshoe is "over-allotment option", because in addition to the shares originally offered, shares are set aside for underwriters. This type of option is the only means permitted by the Securities and Exchange Commission (SEC) for an underwriter to legally stabilize the price of a new issue after the offering price has been determined. The SEC introduced this option in order to enhance the efficiency and competitiveness of the fundraising process for IPOs. (Read more about how the SEC protects investors in Policing The Securities Market: An Overview Of The SEC.)

Price Stabilization
This is how a greenshoe option works:

  • The underwriter works as a liaison (like a dealer), finding buyers for the shares that their client is offering.
  • A price for the shares is determined by the sellers (company owners and directors) and the buyers (underwriters and clients).
  • When the price is determined, the shares are ready to publicly trade. The underwriter has to ensure that these shares do not trade below the offering price.
  • If the underwriter finds there is a possibility of the shares trading below the offering price, they can exercise the greenshoe option.

In order to keep the price under control, the underwriter oversells or shorts up to 15% more shares than initially offered by the company. (For more on the role of an underwriter in securities valuation, read Brokerage Functions: Underwriting And Agency Roles.)

For example, if a company decides to publicly sell 1 million shares, the underwriters (or "stabilizers") can exercise their greenshoe option and sell 1.15 million shares. When the shares are priced and can be publicly traded, the underwriters can buy back 15% of the shares. This enables underwriters to stabilize fluctuating share prices by increasing or decreasing the supply of shares according to initial public demand. (Read more in The Basics Of The Bid-Ask Spread.)

If the market price of the shares exceeds the offering price that is originally set before trading, the underwriters could not buy back the shares without incurring a loss. This is where the greenshoe option is useful: it allows the underwriters to buy back the shares at the offering price, thus protecting them from the loss.

If a public offering trades below the offering price of the company, it is referred to as a "break issue". This can create the assumption that the stock being offered might be unreliable, which can push investors to either sell the shares they already bought or refrain from buying more. To stabilize share prices in this case, the underwriters exercise their option and buy back the shares at the offering price and return the shares to the lender (issuer).

Full, Partial and Reverse Greenshoes
The number of shares the underwriter buys back determines if they will exercise a partial greenshoe or a full greenshoe. A partial greenshoe is when underwriters are only able to buy back some shares before the price of the shares increases. A full greenshoe occurs when they are unable to buy back any shares before the price goes higher. At this point, the underwriter needs to exercise the full option and buy at the offering price. The option can be exercised any time throughout the first 30 days of IPO trading.

There is also the reverse greenshoe option. This option has the same effect on the price of the shares as the regular greenshoe option, but instead of buying the shares, the underwriter is allowed to sell shares back to the issuer. If the share price falls below the offering price, the underwriter can buy shares in the open market and sell them back to the issuer. (Learn about the factors affecting stock prices in Breaking Down The Fed Model and Forces That Move Stock Prices.)

The Greenshoe Option in Action
It is very common for companies to offer the greenshoe option in their underwriting agreement. For example, the Esso unit of Exxon Mobil Corporation (NYSE:XOM) sold an additional 84.58 million shares during its initial public offering, because investors placed orders to buy 475.5 million shares when Esso had initially offered only 161.9 million shares. The company took this step because the demand surpassed their share supply by two-times the initial amount.

Another example is the Tata Steel Company, which was able to raise $150 million by selling additional securities through the greenshoe option.

Conclusion
One of the benefits of using the greenshoe is its ability to reduce risk for the company issuing the shares. It allows the underwriter to have buying power in order to cover their short position when a stock price falls, without the risk of having to buy stock if the price rises. In return, this helps keep the share price stable, which positively affects both the issuers and investors.

For further reading about investing in IPOs, see The Murky Waters Of The IPO Market.

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