Companies wanting to venture out and sell shares to the public can stabilize initial pricing 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. Investment banks and underwriters that take part in the greenshoe process have the ability to exercise this option if public demand 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" arises 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. The legal name is "overallotment option" because, in addition to shares originally offered, additional shares are set aside for underwriters. This type of option is the only SEC-sanctioned method for an underwriter to legally stabilize a new issue after the offering price has been determined. SEC introduced this option to enhance the efficiency and competitiveness of the IPO fundraising process. (Read more about how the SEC protects investors in Policing The Securities Market: An Overview Of The SEC.)
This is how a greenshoe option works:
- The underwriter acts as a liaison, like a dealer, finding buyers for their client's newly-issued shares.
- Sellers (company owners and directors) and buyers (underwriters and clients).determine a share price.
- Once the share price is determined, they're ready to trade publicly. The underwriter then uses all legal means to keep the share price above the offering price.
- If the underwriter finds there's a possibility that shares will fall below the offering price, they can exercise the greenshoe option.
In order to keep pricing 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 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 according to initial public demand. (Read more in The Basics Of The Bid-Ask Spread.)
If the market price exceeds the offering price, underwriters can't buy back those shares without incurring a loss. This is where the greenshoe option is useful, allowing underwriters to buy back shares at the offering price, thus protecting them their interests.
If a public offering trades below the offering price, it's referred to as a "break issue". This can generate a public impression the stock being offered might be unreliable, possibly inducing new buyers to sell shares or to refrain from buying additional shares. To stabilize prices in this scenario, underwriters exercise their option and buy back shares at the offering price, returning those 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 indicates that underwriters are only able to buy back some inventory before the share price rises. A full greenshoe occurs when they're unable to buy back any shares before the share price rises. The underwriter exercises the full option when that happens and buy at the offering price. The greenshoe option can be exercised at any time in the first 30 days after the offering.
A reverse greenshoe option has the same effect on share price as the regular greenshoe option but, instead of buying shares, the underwriter is allowed to buy shares on the open market and sell them back to the issuer, but only if the share price falls below the offering price.
Greenshoe Option in Action
It's common for companies to offer the greenshoe option in their underwriting agreement. For example, Exxon Mobil Corporation (NYSE:XOM) sold an additional 84.58 million shares during an initial public offering, because investors placed orders to buy 475.5 million shares even though the company initially offered only 161.9 million shares. The company took this step because the demand far surpassed the share supply.
The Bottom Line
The greenshoe option reduces risk for a company issuing new shares, allowing the underwriter to have buying power in order to cover short positions if the share price falls, without the risk of having to buy shares if the price rises. In return, this keeps the share price stable, benefiting both issuers and investors.