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.

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.

Related Articles
  1. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  2. Credit & Loans

    Pre-Qualified Vs. Pre-Approved - What's The Difference?

    These terms may sound the same, but they mean very different things for homebuyers.
  3. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  4. Insurance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  5. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  6. Stock Analysis

    GoPro's Stock: Can it Fall Much Further? (GPRO)

    As a company that primarily sells discretionary products, GoPro and its potential falls right in line with consumer trends. Is that good or bad?
  7. Stock Analysis IPO: Is it a 'Buy' or Should You Pass?

    Demand for relationships is always high. Now you will have a way to directly invest in the relationship market. But is it priced fairly?
  8. Options & Futures

    Understanding The Escrow Process

    Learn the 10 steps that lead up to closing the deal on your new home and taking possession.
  9. Options & Futures

    Terrorism's Effects on Wall Street

    Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
  10. Mutual Funds & ETFs

    Scared By ETF Risks? Try Hegding With ETF Options

    With more ETFs to trade, the risks associated with these investments have grown. To mitigate these risks, ETF options are a hedging strategy for traders.
  1. When did Facebook go public?

    Facebook, Inc. (NASDAQ: FB) went public with its initial public offering (IPO) on May 18, 2012. With a peak market capitalization ... Read Full Answer >>
  2. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  3. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  4. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  5. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  6. What kind of assets can be traded on a secondary market?

    Virtually all types of financial assets and investing instruments are traded on secondary markets, including stocks, bonds, ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center