What Is a Reverse Greenshoe Option?

The definition of a reverse greenshoe option, also known as an overallotment option, is a provision used by underwriters in the initial public offering (IPO) process. It is intended to provide increased price stability for the newly-listed security.

Reverse greenshoe options are similar to regular greenshoe options except that they are structured as put options rather than call options. In both cases, however, their objective is to promote price stability following the IPO.

Key Takeaways

  • A reverse greenshoe option is a method used by IPO underwriters to reduce the volatility of the post-IPO share price.
  • It involves using a put option to purchase shares in the open market and sell them back to the issuer at a higher price.
  • The resulting buying pressure from the underwriter is intended to help mitigate against a downward slide in the share price.

Understanding Reverse Greenshoe Options

When participating in an IPO, the lead underwriter of the offering will typically assume the responsibility of ensuring the newly-listed security price remains within reasonable bounds in the weeks following the IPO. To accomplish this, the terms of the underwriting agreement will include a provision allowing the underwriter to buy or sell shares from the issuer in such a way as to dampen the volatility of the share price.

In a typical greenshoe option, this is done by using 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.

By contrast, a reverse greenshoe option consists of 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.

The Securities and Exchange Commission (SEC) introduced this option to enhance the efficiency and competitiveness of the IPO fundraising process.

Example of Reverse Greenshoe Option

For example, suppose an IPO price is set at $20 per share, and the underwriter is given a "reverse greenshoe" put option with a strike price of $20 per share. If the share price declines to $10 per share following the IPO, the underwriter could purchase shares at the market price of $10 and then exercise its put option to sell those shares back to the issuer at $20 per share. The underwriter would help soften the downward slide in the post-IPO stock price by buying in the open market.

History of Reverse Greenshoe Option

The term "greenshoe" arises from the Green Shoe Manufacturing Company, now known as the Stride Rite Corporation. Founded in 1919, Green Shoe was the first company to implement the so-called greenshoe clause into its underwriting agreement. Technically, this clause's legal name is an "overallotment option" because, in addition to the shares originally offered to them, additional shares are set aside for underwriters. This option is the only way an underwriter can legally stabilize a new issue after determining the offering price.