Explore how the greenshoe option works during the initial public offering process, aiding underwriters in stabilizing share prices and protecting their interests.
To keep pricing control, the underwriter oversells or shorts up to 15% more shares than initially offered by the company during the IPO process.
A greenshoe is a clause contained in the underwriting agreement of an initial public offering (IPO) that allows underwriters to buy up to an additional 15% of company shares at the offering price. Investment banks and underwriters that take part in the greenshoe process can exercise this option if public demand exceeds expectations and the stock trades above the offering price.
If a company decides to sell 1 million shares publicly, the underwriters can exercise their greenshoe option and sell 1.15 million shares. When the shares are priced and can be publicly traded, the underwriters can buy back 15% of the shares.
If the market price exceeds the offering price, underwriters can't buy back those shares without incurring a loss. This is where the greenshoe option is useful, allowing underwriters to buy back shares at the offering price, thus protecting their interests.
If a public offering trades below the offering price, it's referred to as a "break issue." This can generate a public impression the stock being offered might be unreliable, possibly inducing new buyers to sell shares or to refrain from buying additional shares. To stabilize prices in this scenario, underwriters exercise their option and buy back shares at the offering price, returning those shares to the issuer.
Here's an example.
The bookrunner will initially be in a short position. They will accept more orders than they have shares issued by the company: Orders taken for 69.0m shares at $5.0, Issue for 60.0m shares.
If the price rises to $6.0 then bank needs more shares to cover being 9.0m shares short. It then exercises its 15.0% green shoe and obtains another 9.0m from the company – but at the $5.0 (less underwriting fees) to cover its order book.
If the price falls to $4.0 then bank won’t exercise the green shoe. Instead the bank will go into the market and buy 9.0m shares which will help push up the price. The bank will make a profit between the issue price and the current market price. Ideally the share price will rise due to the bank activity so the profit will be less than ($5.0-$4.0) * 9.0m.