What is a 'Greenshoe Option'
In security issues, a greenshoe option is an over-allotment option. In the context of an initial public offering (IPO), it is a provision contained in an underwriting agreement that gives the underwriter the right to sell investors more shares than originally planned by the issuer if the demand for a security issue proves higher than expected.
BREAKING DOWN 'Greenshoe Option'
Over-allotment options are known as greenshoe options because, in 1919, Green Shoe Manufacturing Company (now part of Wolverine World Wide Inc.), was the first to issue this type of option. A greenshoe option can provide additional price stability to a security issue because the underwriter has the ability to increase supply and smooth out price fluctuations. It is the only type of price stabilization measure permitted by the Securities and Exchange Commission (SEC).
Practical Workings of Greenshoe Options
Greenshoe options typically allow underwriters to sell up to 15% more shares than the original number set by the issuer, if demand conditions warrant such action. Since underwriters are paid a percentage of the IPO, they are interested in making it as big as possible. The prospectus that is filed with the SEC prior to the IPO spells out the actual percentage and conditions related to the option..
Underwriters use greenshoe options in one of two ways. If the IPO is a success and stock prices surge, the underwriters exercise the option, buy the extra stock from the company at the predetermined price and send those extra shares, at a profit, on to whoever bought them. If the price starts to fall, they buy back the shares from the market instead of the company to cover their short position, supporting the price of the stock.
Some issuers prefer not to include greenshoe options in their underwriting agreements under certain circumstances, such as if the issuer wants to fund a specific project with a fixed amount of cost and does not want more capital than it originally sought.
Examples of Greenshoe Options
A famous example of a greenshoe option at work is the Facebook Inc. IPO in 2012. In that case, the underwriters had agreed to sell 421 million shares of the company at $38. The issue proved to be very popular and they exercised their greenshoe option, effectively selling 484 million shares on the market.
In 2014, underwriters exercised their greenshoe option during the IPO for Alibaba Group Holding Ltd., making it the largest IPO in history at the time, at $25 billion.