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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.
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 use it to maintain the stability of a company’s stock price:
Scenario 1: An underwriter sells 115% of a company’s shares at ₹10 each, resulting in a 15% oversubscription due to high demand.
Scenario 2: If the share price falls to ₹8 post-listing, the underwriter buys back shares at this price, supporting the stock price and earning ₹2 per share profit.
Scenario 3: Should the share price increase to ₹12, the underwriter exercises the greenshoe option to buy shares at ₹10, aiding in price stabilisation.
How to calculate the green shoe option?
Suppose ABC Company plans to issue 1 crore shares at ₹200 each in its IPO.
The underwriter, using the green shoe option, can sell an extra 15 lac shares at the same ₹200 price. If investors show more interest than anticipated, the underwriter can use these extra shares to meet the demand. They buy these additional shares from ABC at the original ₹200 price, providing more capital to ABC.
If the stock price falls (e.g., to ₹8), the underwriter can choose not to exercise the greenshoe option. Instead, they buy back shares at a lower price (₹8), supporting the stock price and earning a profit of ₹2 per share.
If the stock price increases (e.g., to ₹12), the underwriter exercises the greenshoe option. They repurchase shares at the original ₹10 offering price, even though the market price is higher (₹12).
Example:
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.
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:
Benefits of green shoe option
- Price stability
The option helps stabilise 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.
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 instill investor confidence makes it an integral part of the IPO process.
FAQs
The green shoe option is a clause in an IPO underwriting agreement that allows underwriters to sell up to 15% more shares than originally planned if demand exceeds expectations. SEBI’s guidelines permit this option to stabilise post-listing share prices. It’s a tool to manage excess demand and provide additional capital for the issue.
In the context of Alternative Investment Funds (AIFs), the green shoe option functions similarly to its use in IPOs. It allows the fund to issue additional shares beyond the initial offering, typically up to 15%, within 30 days of the IPO. This option is particularly useful for managing excess demand and providing liquidity in the market. It also helps in stabilising the price of the shares post-listing, ensuring a smoother entry into the market for the AIF.
The brown shoe option is a post-IPO price stabilisation mechanism similar to the green shoe option but operates differently. While the green shoe option allows underwriters to sell additional shares in case of excess demand, the brown shoe option enables underwriters to sell shares at a higher price if the market price falls post-IPO. This technique is used to limit the volatility of the share price after the company goes public, providing a safety net against market fluctuations.
The greenshoe and reverse greenshoe options are both used to stabilise the share price after an IPO, but they function in opposite scenarios. The greenshoe option is used when there is excess demand for shares, allowing underwriters to sell additional shares to prevent the stock price from soaring too high. On the other hand, the reverse greenshoe option is used when the share price falls below the offering price.
An underwriter’s option refers to the various roles and decisions underwriters make in financial transactions. Underwriters evaluate and assume the risk of mortgages, insurance, loans, or investments for a fee. They determine the level of risk and set the terms of coverage or loan conditions. In the context of IPOs, underwriters may have options like the greenshoe to manage share price stability post-listing. Their expertise ensures successful capital raising and facilitates informed investment decisions.
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