What is a Greenshoe Option?
A greenshoe option is an over-allotment option. In the context of an initial public offering (IPO), it is a provision in an underwriting agreement that grants the underwriter the right to sell investors more shares than initially planned by the issuer if the demand for a security issue proves higher than expected.
Basics of a Greenshoe Option
Over-allotment options are known as greenshoe options because, in 1919, Green Shoe Manufacturing Company (now part of Wolverine World Wide, Inc. (WWW)) was the first to issue this type of option. A greenshoe option provides additional price stability to a security issue because the underwriter can increase supply and smooth out price fluctuations. It is the only type of price stabilization measure permitted by the Securities and Exchange Commission (SEC).
- A greenshoe option is an over-allotment option in the context of an IPO.
- A greenshoe option was first used by the Green Shoe Manufacturing Company (now part of Wolverine World Wide, Inc.)
- Greenshoe options typically allow underwriters to sell up to 15% more shares than the original issue amount.
- Greenshoe options provide price stability and liquidity.
- Greenshoe options provide buying power to cover short positions if prices fall, without the risk of having to buy shares if the price rises.
Practical Workings of Greenshoe Options
Greenshoe options typically allow underwriters to sell up to 15% more shares than the original amount set by the issuer for up to 30 days after the IPO if demand conditions warrant such action. For example, if a company instructs the underwriters to sell 200 million shares, the underwriters can issue if an additional 30 million shares by exercising a greenshoe option (200 million shares x 15%). Since underwriters receive their commission as a percentage of the IPO, they have the incentive to make it as large as possible. The prospectus, which the issuing company files with the SEC before the IPO, details the actual percentage and conditions related to the option.
Underwriters use greenshoe options in one of two ways. First, if the IPO is a success and the share price surges, the underwriters exercise the option, buy the extra stock from the company at the predetermined price, and issue those shares, at a profit, to their clients. Conversely, 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 stock to stabilize its price.
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 and has no requirement for additional capital.
Real Life Example of Greenshoe Options
A well-known example of a greenshoe option at work occurred in the Facebook Inc. (FB) IPO of 2012.
The underwriting syndicate, headed by Morgan Stanley (MS), agreed with Facebook, Inc. to purchase 421 million shares at $38 per share, less a 1.1% underwriting fee. However, the syndicate sold at least 484 million shares to clients – 15% above the initial allocation, effectively creating a short position of 63 million shares.
If Facebook shares had traded above the $38 IPO price shortly after listing, the underwriting syndicate would’ve exercised the greenshoe option to buy the 63 million shares from Facebook at $38 to cover their short position and avoid having to repurchase the shares at a higher price in the market.
However, because Facebook’s shares declined below the IPO price soon after it commenced trading, the underwriting syndicate covered their short position without exercising the greenshoe option at or around $38 to stabilize the price and defend it from steeper falls.