Greenshoe Option

The greenshoe option is a special clause used in an underwriting agreement prepared in the US wherein the underwriter is under no more restrictions to sell the planned number of shares. Instead, this arrangement gains them the right to sell more shares to investors than what is planned.

This provision is available in the US share offering procedures, including the Initial Public Offering (IPO). This process helps take control over the frequent fluctuations of the newly listed stocks in the market.

• The greenshoe option refers to a clause used in an underwriting agreement during an IPO wherein this provision provides a right to the underwriter to sell more shares to the investors than an issuer planned if demand is higher than expected for the security issued.
• They gave the "Greenshoe Option" after the firm named "Green Shoe Manufacturing" (the first to incorporate the greenshoe clause in the underwriter's agreement).
• The greenshoe option is based on the far-sighted vision, which forecasts the increased market demand for their stocks. It also refers to their popularity among the general public and the investor's faith in them to perform in the future and provide them excellent returns. 

Greenshoe Option is a term coined after the firm named Green Shoe Manufacturing, which was the first to incorporate the greenshoe clause in its underwriter’s agreement. The arrangement is based on its far-sighted vision, which foresees the increased demand for their stocks in the market. The concept also refers to their popularity among the general public and the investor’s faith in them to perform in the future and give them very good returns.

This option benefits the company, underwriters, markets, investors, and the economy. However, investors must read the offered documents before investing for optimum returns. To know what is greenshoe option and  how it works, let us have a step-wise look at the process:

1. When a company wants to raise capital for some of its future developmental plans, it can raise money through an IPO.
2. During an IPO, a company declares an issue price for its securities and announces a particular quantity of stocks it will issue (suppose 1 million securities at $5.00 each). In the case of a blue-chip company or a company with very good background and statistics, demand for such security goes uncontrollably up. Due to this, prices will rise.
3. Secondly, the existing subscriptions are way more than expected (e.g., 500,000 actual vs. 100,000 expected). In this case, the number of shares allotted to each subscriber comes down proportionately (2 numbers actual vs. 10 expected).
4. Thus, there is a gap between the required and actual prices due to the unexpected demand for this security. To control this demand-supply gap, companies develop the “Greenshoe Option.”
5. In this type of option, the company declares its strategy to exercise the greenshoe option during its proposal for IPO. Hence, it approaches a merchant banker in the market, who will act as a “stabilizing agent.”
6. At the time of the issue of securities, the stabilizing agent borrows certain shares from promoters of the company to allow them additional subscribers in the market. In this way, the security price is not dramatically raised due to demand-supply inconsistency when the trading starts.
7. The money raised from this additional market offering is not deposited in any party’s accounts. Instead, this money is deposited in an Escrow account created for this process.
8. Once the trading starts in the market, this stabilizing agent can withdraw money deposited in the escrow account, as per requirement, purchase back excess shares from the shareholders, and repay the company’s promoters.
9. The entire process of lending shares by promoters and repaying the same after a particular period by the stabilizing agent is called the “stabilizing mechanism.”

1. The entire stabilizing mechanism must complete within 30 days. Therefore, the stabilizing agent has a maximum of 30 days from listing the company he needs to borrow and return the required shares for further process. If he cannot complete the process within this timeline and can return only part of the total shares to the promoters, the issuing company will allow the remaining shares to be the promoters.
2. Promoters can lend up to 15.0% of the total issue to the stabilizing agent.
3. This option was first exercised in 1918 by a firm named Green Shoe Manufacturing (now known as Stride Rite Corporation). It is also known as the “Over-allotment Option.”
4. The greenshoe option is a price stabilization tool. The SEC (Securities and Exchange Commission) regulates and permits exercising it. Accordingly, if the company wishes to exercise this option in the future, it needs to mention all detailed red herring prospectus it shall publish during the issue of securities.
5. The stabilizing agents (or underwriters) must execute separate agreements with the company and the promoters. They mention all details about the price and quantities of the listed shares. It also says deadlines for the stabilizing agents.

Let us consider the following greenshoe option examples to check how to exercise it:

Example 1

If the total issue of an entity is 1 million shares, the arrangement allows the concerned underwriters or stabilizing agents the right to sell up to 150,000 shares for allotment to excess subscribers.

Example 2

Facebook’s popularity led to a rise in demand for the company’s shares in 2012. Given this opportunity, the social media giant issued its IPO and per the greenshoe provision, the underwriters had a chance to raise more funds by selling more shares. This is how the greenshoe option in IPO benefitted both the company and the underwriters individually.

• The greenshoe option helps in price stabilization for the company, market, and economy. It controls the shooting up of a company’s shares due to uncontrollable demand and aligns the demand-supply equation.
• This arrangement benefits the underwriters (who sometimes act as the stabilizing agents for the company). They borrow the shares from promoters at a special price and sell them higher to investors once they go up. When prices go down, they purchase shares from the market and return them to the promoters. It is how they earn profits.
• This mechanism is also beneficial to investors as it works to stabilize prices. Thus, it makes it cleaner and more transparent to investors, helping them make a better analysis.
• It is beneficial for the markets because they intend to correct the prices of the company’s securities in the market. Therefore, merely shooting up costs due to increased demand is an incorrect measure of the share’s prices. Hence, the company tries to direct the investors rightly by analyzing other things rather than only demand. This helps them assess the correct share prices.

This article is a guide to Greenshoe Option and its meaning. Here we explain it with examples, advantages, and guidelines to follow. You may learn more about investment banking from the following articles: -

• Reason for Share Split?
• Forward Integration Definition
• Private Placement of Shares