What Is an IPO Greenshoe Option? Example Explained

An Initial Public Offering (IPO) is characterized by the transition of a company from private to public ownership, where shares are offered to investors. 

A very important part of the process is the Greenshoe Option, otherwise known as the over-allotment option. It enables the underwriters to sell more shares beyond the initial amount, usually 15 percent, to level the stock in the market after the IPO.

Understanding the Greenshoe Option

The Greenshoe Option provision in the underwriting agreement grants the underwriters permission to sell more shares than they had originally projected should demand exceed their expectations of anticipated supply. 

This is done primarily to manage volatility and stabilize a stock price during the first days of trading. The term "Greenshoe" is noteworthy because it derives from the Green Shoe Manufacturing Company (which is now owned by Wolverine World Wide, Inc.), the first company to utilize such a structure.

How Does It Work?

Over-Allotment: Underwriters are allowed to sell up to 15% class more shares than originally intended. If, for instance, a company wants to sell 1 million shares, the underwriters can sell 1.15 million shares, including an additional 150,000 shares.

Price Stabilization: If the stock price falls below the offering price post-IPO, underwriters can buy back those extra shares, thus covering their short position in support of the stock price. 

In other words, if the price rises, underwriters can exercise the Greenshoe Option to buy shares from the company at the offering price to avoid incurring a loss from buying back shares at higher market prices.

Explaining the Example

XYZ Corporation completes its initial public offering (IPO) with 1 million shares offered at $10 each to investors. Demand is high; therefore, the underwriters of the issue exercise the Greenshoe option and sell 150,000 additional shares, giving a total of 1.15 million.

Scenario 1: Price Drops Post-IPO: If after an IPO, XYZ Corp's stock drops to $9, then the underwriters can purchase 150,000 extra shares at this lower price to cover their shorts. The idea behind it is to soak up the excess supply with a view to stabilizing or increasing the stock price.

Scenario 2: Price Rises Post-IPO: If the stock price rises to $12, the underwriters can then invoke the Greenshoe Option to buy the additional 150,000 shares from the company at the original offering price of $10. Such options prevent any loss when the stock price climbs, forcing underwriters to buy back shares at a higher market price.

Benefits of the Greenshoe

Price Stability: It counteracts sharp price volatility on the stock in the first days of trading, thus protecting the confidence of investors.

Flexibility for Underwriters: The component gives underwriters the chance to further tap into the secondary markets and modulate the supply of shares in accordance with the circulation.

Protection of Investors: Price stabilization serves as an active hedge from substantial losses by investors, arising primarily from stock price volatility.

Conclusion

The Greenshoe option is a supervisory tool for underwriters in dealing with IPOs so that prices get stabilized and stock price volatility is reduced. With the option providing an opportunity for the shareholders to liquidate extra shares, this has a key role to play in ensuring that the IPO goes through more smoothly and could protect investors during the critical early trading days.

Frequently Asked Questions

1. What is an IPO Greenshoe Option?

An IPO Greenshoe Option, also known as an over-allotment option, is a provision in an initial public offering (IPO) that allows underwriters to sell additional shares beyond the initial offering size. This helps stabilize the stock price after the IPO.

2. How does a Greenshoe Option work?

Underwriters can over-allot shares (sell more than initially planned) and later buy them back at the IPO price to manage demand fluctuations. If the stock price rises, they exercise the option to purchase extra shares from the company at the IPO price, increasing the overall offering size.

3. Why is it called a "Greenshoe Option"?

The term originates from Green Shoe Manufacturing Company, the first company to use this mechanism in an IPO. The option has since been widely adopted in stock markets.