DEFINITION of 'Reverse Greenshoe Option'

A reverse greenshoe option is a provision contained in an public offering underwriting agreement that gives the underwriter the right to sell the issuer shares at a later date. It  is used to support the share price in the event that after the IPO the demand for the stock falls.

The underwriter would purchase shares for the depressed price in the market, and sell them to the issuer at a higher price by exercising the option. This activity of buying a large amount of shares in the open market is intended to stabilize the price of the stock.

BREAKING DOWN 'Reverse Greenshoe Option'

A reverse greenshoe option differs from a regular greenshoe option as they are put and call options respectively. A reverse greenshoe option is essentially a put option written by the issuer or primary shareholder(s) that allows the underwriter to sell a given percentage of shares issued at a higher price should the market price of the stock fall.

In contrast, a regular greenshoe option is essentially a call option written by the issuer or primary shareholder(s) that allows the underwriter to buy a given percentage of shares issued at a lower price to cover a short position taken during the underwriting. Both methods have the same effect of market price stabilization, however it is believed that the reverse greenshoe option is more practical.

Greenshoe Options Take Foothold

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 way an underwriter can legally stabilize a new issue after the offering price has been determined. The SEC introduced this option to enhance the efficiency and competitiveness of the IPO fundraising process.

If this all sounds like it may not be in the best interest of small shareholders, think again. The New York Federal Reserve noted in a white paper that greenshoes help even out demand. "Under this option, which is sanctioned by the Securities and Exchange Commission, the underwriters sell to the public a certain number of extra shares, usually 15 percent of the issuance, in addition to the original offering that they purchased from the issuing firm. If demand for the stock is unexpectedly high, the extra shares reduce upward price pressure and are issued to the underwriters retroactively at the IPO price. However, if demand for the stock is unexpectedly low, the underwriters buy back the extra shares in the marketplace, thus helping to stabilize the price. In economic terms, the 'greenshoe' option lends some elasticity to the supply of shares so that the price impact of demand fluctuations is dampened."

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