What is a Green Shoe Option?

Initial Public Offerings (IPOs) offer access to promising companies during their early stages, potentially resulting in significant returns and provide the opportunity for capital appreciation as the company grows and expands. These are just some of the reasons why IPOs have become quite popular with lakhs of investors applying for them regularly, often leading to situations of over-subscription or skewed demand and supply.

In the world of initial public offerings (IPOs), certain mechanisms exist to ensure a smooth overall process and keep the market stabilised. One such mechanism is the Greenshoe option, also known as an over-allotment option. In this blog post, we will explore the concept of the Greenshoe option, its role in the underwriting process, guidelines for its implementation, and why it is considered an important tool for both issuers and underwriters.

The Greenshoe Option

• The Role Of The Underwriter

  Before we delve into the concept of the Greenshoe option, it is important to understand the critical role of the underwriter in the IPO process. An underwriter, typically an investment bank or a financial institution, plays a vital role in facilitating the successful launch of an IPO. They help the issuing company determine the offering price, allocate shares, and navigate the complexities of the IPO process.

  When a company decides to go public, it enters into an underwriting agreement with the underwriter. The underwriter commits to purchasing the shares from the company at a predetermined price and then reselling them to the public. This commitment provides the issuing company with the assurance of raising the desired capital and the underwriter with the opportunity to profit from the offering.

  During the underwriting process, the underwriter gauges market demand for the shares. If there is strong investor interest, they may find themselves in a situation where the demand for the shares exceeds the number of shares initially offered. This is where the Greenshoe option comes into play.

• Definition

  The Greenshoe option, also known as an over-allotment option, is a provision in the underwriting agreement that grants the underwriter the right to purchase additional shares from the issuing company at the offering price. These additional shares are referred to as "Greenshoe shares."

• Purpose

  The purpose of the Greenshoe option is to address the potential imbalance between demand and supply during the IPO process. If there is excessive demand for the shares, the underwriter can exercise the Greenshoe option to purchase additional shares from the company. This allows the underwriter to meet the demand from investors without putting undue pressure on the market or the issuing company.

  By having the ability to purchase Greenshoe shares, the underwriter can stabilise the stock price in the aftermarket. If the price of the newly issued shares rises significantly above the offering price, the underwriter(s) can sell the additional shares acquired through the Greenshoe option at the market price, profiting from the price difference. This process helps maintain a more stable trading environment and minimises price volatility.

  The decision to exercise the Greenshoe option is typically based on various factors, including market conditions, investor demand, and the underwriter's assessment of the stock's performance. The underwriter carefully evaluates these factors to determine the optimal timing and quantity of Greenshoe shares to be acquired and subsequently sold in the market.

What Are the Types of Greenshoe Options? 

There are three main types of Greenshoe Options:

1. Full Greenshoe Option

In a full Greenshoe, the underwriters are allowed to sell up to 15% more shares than initially offered. This helps meet high demand and stabilises the stock price after the IPO. The company authorises additional shares, and the underwriters can buy them to cover oversubscriptions.

2. Partial Greenshoe Option

In a partial Greenshoe, the underwriters are permitted to sell only a portion of the extra shares (less than 15%). This provides some flexibility to handle demand fluctuations but doesn’t fully capitalise on oversubscription.

3. Reverse Greenshoe Option

Unlike the traditional Greenshoe, a reverse Greenshoe allows underwriters to buy back shares to stabilise the price when the stock falls below the offering price. It helps prevent excessive price drops and ensures market stability after listing.

Each of these options helps underwriters manage price volatility, ensuring a smooth transition for the company’s shares into the public market.

Guidelines for the Greenshoe Option Process

To ensure transparency and fairness, specific guidelines govern the implementation of the Greenshoe option. These guidelines may vary based on regulatory requirements and the terms agreed upon between the issuer and the underwriter. Key considerations include:

• Option Size

  The Greenshoe option is typically granted as a percentage of the original offering size. It allows the underwriter to purchase additional shares, usually up to 15% of the original offering size, although this can vary.

• Exercise Period

  The Greenshoe option has a limited exercise period, usually ranging from 30 to 60 days from the IPO's pricing date. This time frame ensures that the underwriter has sufficient time to assess market demand and exercise the option if necessary.

• Price Determination

  The exercise price of the Greenshoe option is typically set at the offering price. This ensures that the underwriter can acquire additional shares at the same price as the original offering, maintaining consistency in the pricing structure.

Importance of the Greenshoe Share Option

• Managing Over-Allotments

  One of the primary purposes of the Greenshoe option is to manage over-allotments. If the demand for shares exceeds the original offering size, the underwriter can exercise the option to purchase additional shares, meeting market demand without putting excessive pressure on the issuer.

• Price Stabilisation

  The Greenshoe option plays a significant role in stabilising the price of newly issued shares. By allowing the underwriter to purchase additional shares and sell them in the aftermarket, it helps prevent excessive price volatility and maintains a more stable trading environment.

• Enhancing Investor Confidence

  The presence of a Greenshoe option can enhance investor confidence in an IPO. Investors may perceive the option as a signal of the underwriter's commitment to support the stock price, which can positively impact investor sentiment and participation in the offering.

The Greenshoe Example 

Here’s an example to help you better understand how the Greenshoe Option works in an IPO.

Imagine that Company ABC is going public with an IPO of 5 Lakh shares, priced at ₹ 50 per share, with a lot size of 300 shares. 

The underwriters (banks or financial institutions managing the IPO) also have the Greenshoe Option, which allows them to sell up to 15% more shares if there is strong demand.

Here’s how it works step-by-step:

1. Original IPO Plan:
   Company ABC plans to offer 5 Lakh shares, which will raise ₹ 25,000,000 (5,00,000 shares x ₹ 50).
2. Oversubscription:
   Due to high demand from investors, more people want to buy shares than the 500,000 originally offered. To satisfy this demand, the underwriters use the Greenshoe Option.
3. Additional Shares Issued:
   The Greenshoe Option allows the underwriters to issue 15% more shares, which is an additional 75,000 shares (15% of 5,00,000). So, the total number of shares offered becomes:
   500,000 (original shares) + 75,000 (Greenshoe shares) = 5,75,000 shares
4. Total Amount Raised:
   With the extra 75,000 shares sold at ₹ 50 per share, Company ABC now raises ₹ 28,750,000:
   575,000 shares × ₹ 50 = ₹ 28,750,000 
5. Price Stabilisation:
   If Company ABC’s stock price rises above ₹ 50 after listing, the underwriters can exercise the Greenshoe Option by purchasing the additional 75,000 shares from the company at the offering price to stabilise the price in the market. This prevents the price from rising too quickly due to high demand.

In this example, the Greenshoe Option allows Company ABC to meet excess demand, raise more capital, and stabilise its stock price after the IPO.

How do Greenshoe Options in IPOs Benefit Investors and Companies? 

Greenshoe Options in IPOs offer several advantages to both investors and companies:

• Benefits for Investors:

1. Price Stability: The underwriters can stabilise the stock price if it fluctuates, thus, protecting investors from sudden price drops or excessive surges after the IPO.   
2. Reduced Risk: Investors are less exposed to market volatility because the Greenshoe Option allows underwriters to adjust the number of shares available, balancing supply and demand.
3. Greater Access to Shares: In an oversubscribed IPO, investors get increased opportunities to buy shares, as the underwriters can issue additional stock through the Greenshoe Option.

• Benefits for Companies:

1. Increased Capital: Companies can raise more money than initially planned by selling up to 15% more shares, providing additional resources for business growth.
2. Enhanced Market Confidence: Investors feel more secure knowing that underwriters can stabilise the stock price. This can encourage broader participation and a stronger market debut.
3. Controlled Volatility: The company’s stock price experiences fewer extreme fluctuations, leading to a smoother transition into the public market and promoting long-term investor trust.

In short, Greenshoe Options help maintain balance in the market, benefiting both investors and companies.

In Summation

The Greenshoe option serves as a crucial tool in the underwriting process, providing flexibility to manage over-allotments and stabilise the price of newly issued shares. Its guidelines and implementation ensure transparency and fairness for all parties involved. Understanding the Greenshoe option's significance empowers issuers, underwriters, and investors to navigate the IPO landscape with greater confidence. If you are planning to invest in upcoming IPOs then open a FREE m.Stock Demat account and benefit from 100% paperless application process (backed by ASBA), easy monitoring courtesy separate reporting and so much more!