The greenshoe option permits the banks that invest in the initial public offerings (IPO) to purchase and sell 15 percent more shares at the same price as the company that issued the IPO originally was planning to sell. The clause will be activated when the demand for shares is higher positive than expected, and the shares are trading on the secondary market at or above the price of the offering. If the demand is not strong and the stock price is lower than the price of the offering, the syndicate can't use its right to sell additional shares. The contract clause can be exercised for up to 30 calendar days following the IPO and is named after the Green Shoe Company, the first company to sign a contract to sell additional shares when it was first listed in 1960.
Working
Over-allotment alternatives are known as greenshoe options because, around 1919, Green Shoe Manufacturing Company (now part of Wolverine World Wide, Inc. (WWW), also known as Stride Rite) was the first to offer this kind of option. Greenshoe options provide additional stability in the price of security issues because the underwriter can increase supply and smooth price fluctuation. It is the sole type of price stabilization option that is permitted to be used by the Securities and Exchange Commission (SEC). Greenshoe options generally permit underwriters to sell up to 15 percent more shares than the originally set amount by the issuer as long as 30 days following the IPO if demand conditions require this type of move.
For instance, If a company tells the underwriters to offer 200 million shares, they may issue 30 million shares through exercising the greenshoe choice (200 million shares + 15 15%) because underwriters earn their commission in the form of an amount of the IPO and have an incentive to make the IPO as large as is possible. The prospectus that the company issuing it submits to the SEC before the IPO will provide the exact percentage of the IPO and the conditions that apply to the option.
Greenshoe options are used by underwriters using two methods. Suppose the IPO is successful and the price of shares rises. In that case, the underwriters take advantage of the option to purchase the additional shares from the company for the set price and then issue the shares, with profit, to their customers. If prices begin to drop, they purchase the shares from the market instead of the company to pay for their short position and help the stock stabilize its value. Certain issuers do not want to incorporate greenshoe options into their underwriting agreements in certain conditions, for example, when the issuer is looking to finance a particular project in a predetermined amount but does not need capital addition.
What Does It Mean For Individual Investors?
You may be wondering what the impact of a greenshoe choice is on investors. On the one hand, it impacts investors because it increases the number of shares available. This increase in liquidity in the market could lead to greater numbers of investors being able to purchase IPO stock. However, only certain investors can access the IPO market as a greenshoe option does not necessarily alter the situation.
The greenshoe market may impact individual investors following the IPO after the investors who were initially involved resell their shares to the market for sale to the public. If a greenshoe option is used, more shares went on the market than originally planned. In the end, the shares available may be accessible to investors.
Partial, Full, and Reverse Greenshoes
The number of shares an underwriter purchases back determines whether they take advantage of a partial or full greenshoe. A partial greenshoe means that underwriters only can purchase back some stock before the price of the shares increases. Full greenshoes occur when they're not able to buy back shares before the time when the price increases. The underwriter exercises the entire option when this happens and buys at the offering price. The greenshoe option can be used anytime within the first 30 days following the offer.
A reverse greenshoe choice has the same effect on the price of shares as the standard greenshoe option; however, instead of purchasing shares, the underwriter has the option to purchase shares from the market and return them to the issuer only if the price falls below the offer price.
