Approximately six decades ago, in 1963, the Greenshoe manufacturing company introduced an innovative IPO concept on the New York Stock Exchange (NYSE). What set this IPO apart from others was its capacity to address oversubscription. In essence, if the demand for the IPO exceeded the available shares, the underwriters could release a higher percentage of shares to accommodate the surplus demand.
This pioneering practice gained global acceptance, and the IPO provision came to be known by the name of the company that initiated this practice.
In this blog, we will take a comprehensive dive into the green shoe option within an IPO, covering its various types, calculations, and the advantages it offers.
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What is the green shoe option?
The green shoe option is used by companies during their initial public offerings (IPOs). Its primary objective is to maintain stability in the stock price when there is a surge or fall in demand for shares following the IPO. Under the green shoe option, underwriters are granted the authority to issue additional shares, usually up to 15% of the original shares offered, in response to heightened demand.
This meets the demand for subscriptions as well as helps to maintain the price of the share. The additional shares are lent by the promoters and not by the company.
To gain a deeper understanding of the green shoe option, let us examine three different situations and explore how underwriters utilise it to maintain the stability of a company’s stock price:
Scenario 1
Imagine a company is offering its shares through an underwriter for ₹10 per share. The underwriter successfully sells 115% of the available stock at the offering price. Essentially, this means that the underwriter is left with a 15% shortfall, meeting the strong demand for the shares.
Scenario 2
Now, suppose that after the stock is listed, its price drops to ₹ 8. In this case, the underwriter chooses not to exercise the greenshoe option but instead buys back the stock at the lower price of ₹ 8. This buyback action helps bolster the stock’s price. As a result, the underwriter realises a profit of ₹ 2 per share.
Scenario 3
If the stock’s price rises to ₹12, the underwriter decides to exercise the greenshoe shares option, which grants them the privilege to repurchase the shares at the original offering price of ₹ 10, even though the market price has increased to ₹12. This strategic move allows the underwriter to acquire shares at a lower cost, contributing to stabilising the stock price.
How to calculate the green shoe option?
Imagine ABC wants to become a public company and decides to go for an IPO of 1 crore shares to the public at ₹200 each. To do this, they team up with an investment bank. This bank promises to help with the IPO, using a green shoe option.
This green shoe option lets the bank sell an extra 15% of shares (which is 15 lac shares) at the same ₹200 price. So, in total, they can sell up to 1.15 crore shares.
Now, let’s say many investors want to buy ABC’s shares, more than what ABC initially planned to sell. In this case, the bank can use the green shoe option to sell those extra 15 lac shares. They buy these shares from ABC at the original ₹200 price, giving ABC more money.
When the IPO is oversubscribed, the share price often goes up. So, in our example, the share price could rise from ₹200 to ₹215. This is good news for investors who bought the shares at ₹200 because now they can sell them for ₹215, making a profit.
To keep things stable, the bank uses the 15 lacs shares they bought from ABC to balance things out. If the share price goes below ₹200, the bank can buy shares from the market to keep things steady.
Also read: What sets an SME IPO apart from a regular IPO?
Companies that used the green shoe option
Let’s explore how these prominent companies used the green shoe option to manage their stock prices during their respective IPOs:
List of Indian companies who included the green shoe option in their red herring prospectus
Source: Research Gate
Saudi Aramco
State-owned oil company Saudi Aramco issued an additional 450 million shares to raise their IPO to $29.4 billion, by exercising its green shoe option. Aramco initially raised $25.6 billion in its IPO in December by selling 3 billion shares at 32 riyals ($8.53).
Alibaba Group Holding Limited
Back in September 2014, Alibaba made history by going public in what was the largest IPO ever at the time. To address market volatility, the underwriters exercised the green shoe option, buying an extra 48 million shares from the company. This move brought the total number of shares sold to 320 million and played a crucial role in stabilising the stock price during the tumultuous market conditions.
In each case, the green shoe option proved to be a valuable tool in managing stock price stability and addressing the challenges of volatile markets during these significant IPOs. It allowed underwriters to respond effectively to fluctuating demand, ultimately benefiting both the companies going public and the investors participating in these landmark offerings.
Also read: Understanding the difference between equity and debt IPO for the right investment
Benefits of green shoe option
The green shoe option offers several benefits to Indian companies, underwriters, and investors:
Price stability
The option helps in stabilising the stock price, preventing wild swings that can deter investors.
Meeting demand
Indian IPOs often witness high demand due to the growing investor appetite in the country. The green shoe option allows companies to meet this demand effectively.
Investor confidence
Investors gain confidence in an IPO when they see that measures are in place to address excess demand. This can lead to increased investor participation.
Risk mitigation
For underwriters, the green shoe option acts as a risk management tool. They can purchase additional shares at the offering price if needed, avoiding potential losses in case the market price exceeds the offering price.
Conclusion
The green shoe option is a vital tool in the world of IPOs, offering a balancing act between the interests of companies, underwriters, and investors. Its ability to maintain price stability, meet high demand, and instil investor confidence make it an integral part of the IPO process.
As companies continue to seek opportunities in the public markets, the green shoe option will remain a key player in their success stories.
