Greenshoe Option - Definition and Types

A greenshoe option is a post-listing stabilisation mechanism that allows underwriters to sell up to 15% more shares than the original IPO size when demand is strong. To facilitate this, the stabilising agent (usually the lead merchant banker) borrows shares from promoters or existing shareholders and sells them during the IPO, creating a short position.

If the stock remains above the issue price, the stabilising agent acquires additional shares from the issuer (or exercises the greenshoe arrangement) to close the short position.

After listing, if the stock falls below the issue price, the merchant bankers buys shares on the secondary market and returns them to the lenders, helping to support the stock price.

What is a Greenshoe Option

The greenshoe option is a clause in an IPO that allows underwriters to sell up to 15% more shares than originally planned if demand exceeds supply.

Also referred to as the over-allotment option/clause, it is a tool to support the share price after listing by buying back shares if they fall below the IPO price.

The greenshoe clause helps greatly in preventing extreme stock volatility. Here are some key aspects worth noting -  

• Permitted Period: The stabilisation period is generally limited to 30 days after listing 
• Mechanism: Underwriters borrow additional shares from promoters for selling to the public, thereby creating a short position. 
• Price Support: If the stock price falls below the issue price, underwriters will buy back shares in the market to return them to the promoter. This creates buying pressure. 
• High-Demand Environment: If the stock performs well and remains above the issue price, the underwriters may exercise their option to buy additional shares from the company. This closes the short position. 

The Greenshoe term originates from the Green Shoe Manufacturing Company (now called Stride Rite Corporation), an American shoe company. It was the first such entity to leverage this specific mechanism as a stabilising agent in an IPO in 1960. Over time, this became standard practice, and the term "over-allotment option" was replaced by the name of the company that pioneered the method. 

Here are some examples of greenshoe options that will illustrate the concept:

• High Demand/Oversubscription: If an IPO with 10 crore shares is oversubscribed, the company will exercise its greenshoe option to issue an additional 1.5 crore shares (15% of the issue). This allows investors to get more shares, while the company can raise more capital. 
• Post-Listing Drop in Prices: Suppose a share is listed at ₹200, but dips to ₹190. In this case, the underwriter may use funds from over-allotment to buy shares at ₹190 from the open market. This provides price support to combat future crashes. 

The most common use is seen in IPOs where considerable demand volatility is anticipated, such as large PSU divestments or new-age tech firms. This helps maintain investor confidence significantly. 

Why Is It Also Called the Over-Allotment Clause

Greenshoe option is often referred to as an over-allotment clause in IPOs. This is because it is a price stabilisation mechanism that allows underwriters to sell more shares than originally planned (in the event of high share demand post-listing).

It is regulated by SEBI in India to prevent stock prices from falling below the issue price immediately after listing. It is called the over-allotment clause since it authorises the lead manager/underwriter to create the over-allotment of shares. This means they sell more shares to investors than the company originally intended to issue (or planned). 

Hence, underwriters sell more shares to investors than the company has generated. The money from the extra shares will be kept in a separate account for 30 days to buy back shares if required. The underwriters will then allot or provide an additional percentage of the issue size to the general public. 

How Does the Greenshoe Option Work in an IPO?

Here's how the greenshoe option works: 

• Initial Over-Allotment: Underwriters usually over-allot more shares than the issuer originally planned to sell. This leads to a short position for the underwriters. 
• Stabilisation Period: The option is usually available for 30 days post the IPO pricing. 

Let's look at two scenarios below: 

Scenario 1: 

If the stock price rises, the underwriter cannot buy back the shares at a low price. Rather, they use a greenshoe option to buy additional shares from the company at the original IPO price. They will use the shares to cover the short position, resulting in a no-profit, no-loss outcome. 

Scenario 2: 

In case the share price goes below the issue price. The underwriter will then buy back shares from the market, thereby increasing demand and supporting the share price. The underwriter will leverage the repurchased shares to close the initial short position.

Types of Greenshoe Options: 

• Full: The underwriter buys an additional 15% of shares from the company if the price remains high. 
• Partial: The underwriter will use market buybacks to buy back some shares and buy only the remaining shorted shares from the company. 
• Reverse: The underwriter will sell shares back to the issuer. This is usually done to counter a severe price decline. 

Objectives of Greenshoe Options

The main objective of a greenshoe option in an IPO is to stabilise prices. Here are some of the other key objectives - 

• Stabilising Prices: In case the stock price falls below the IPO price, underwriters may buy back shares to stabilise the market. 
• Managing Oversubscription: This enables underwriters to meet the robust market demand for shares. 
• Building Investor Confidence: This signals a smoother, more managed company IPO debut for investors. It reduces the fear of immediate price dips. 
• Capital and Flexibility: Offers greater flexibility to raise additional capital in the event of high demand. This is done without setting a high, risky price initially. 

SEBI Rules Associated with Greenshoe Options

Some of the key greenshoe option SEBI regulations include the following - 

• Authorisation: The issuer should be authorised by a resolution of the general meeting. The arrangement should be approved in the offer document. 
• Stabilising Agent: A lead manager must be appointed as the stabilising agent, responsible for the price stabilisation process. 
• Maximum Threshold: The over-allotment will be limited to 15% of the total shares offered in the IPO. 
• Time Limitations: The option may be exercised only within 30 days of the listing date. 
• Disclosure: Companies have to clearly reveal the usage of the greenshoe option in their DRHP (draft red herring prospectus). 
• Debt Issue Cap: In the case of debt issues, SEBI has capped the overallocation. The rules require that the added funds raised cannot surpass the size of the original base issue. 
• Price Action: If the share price falls below the offer price, the stabiliser will buy back shares. If the price stays on the higher side, the shares are purchased from the issuer. 

Stabilising Agent in an IPO

A stabilising agent in the IPO is usually the lead underwriter or the merchant banker appointed to support share prices in the secondary market for up to 30 days post-listing. Under the greenshoe option, they may buy back shares if the price falls below the offer price. This creates demand to lower volatility accordingly. Here are some major aspects of stabilising agents in IPOs: 

• Action/Role: The agent (usually the lead banker) buys back shares from the market using funds from the over-allotment in a separate escrow account. 
• Greenshoe Option: Agents may buy back up to 15% of the total issue size, sometimes borrowing shares from promoters for managing the process. 
• Objective: Combating a sharp drop in stock prices immediately after the listing, thereby enabling price stability and safeguarding investors. 
• Compliance: The appointment should be in full compliance with regulatory bodies such as SEBI. 

Greenshoe Option Example

Here is an example of a greenshoe option being used: 

Let's say Company X is launching its IPO. The original issue is 2 crore shares at ₹200 per share. The greenshoe option, if exercised, allows an additional 15%, i.e., 30 lakh shares. In this case, the underwriter will sell 2.30 crore shares (the original 2 crore shares plus an additional 30 lakh shares) to manage higher demand. 

Scenario 1: The stock price shoots up due to high demand 

If the price rises to ₹220, the underwriters will exercise the greenshoe option to buy 30 lakh shares from Company X at ₹200 and cover the additional shares sold. The company thus raises higher capital, while the price is stabilised. 

Scenario 2: The stock price falls due to low demand 

If the price falls to ₹190, the underwriter will buy back 30 lakh shares from the market at ₹190 to build demand and support the price. So, the underwriter makes a profit (buys at ₹190 and sells at ₹200), while the share price is prevented from dropping any further. 

Benefits of a Greenshoe Option

Some of the advantages of a greenshoe option include the following: 

• Price Stabilisation: The main advantage here is maintaining the stock's floor price. If the share price falls below the IPO price, the underwriters may use over-allotted shares to buy back stock and mitigate any steep decline. 
• Lower Market Volatility: By absorbing excessive selling pressure, the option will help limit price swings during the initial trading days. This ensures a smoother market debut. 
• Higher Investor Confidence: Knowing that a stability mechanism is in place automatically boosts investor confidence. This often leads to higher IPO participation rates. 
• Higher Capital Raising: If there is a highly coveted IPO, the issuing company may raise more funds by issuing more shares than originally planned. 
• Efficient Market Balancing: The option ensures ample flexibility for managing demand. If the issue is oversubscribed, the company may meet the high demand by issuing more shares, thereby boosting its market reputation. 

Does a Greenshoe Option Guarantee Good Listing Performance?

No, a greenshoe option does not guarantee good listing performance or high stock prices. The option may serve as a stabilising agent, with underwriters buying back shares in the open market if the price falls below the IPO offer price. This supports the share price.

This also helps keep stock prices close to the offer prices during the first 30 days of trading, while controlling demand. If a stock is hugely successful, the underwriters can issue more shares to meet demand, thereby helping combat price spikes that are hard to control.

This builds confidence that the underwriter remains committed towards supporting the stock. Despite these benefits, there are limitations you should account for.

For instance, there may be a negative market reaction at times when buyback capacity is insufficient to prevent a major price drop.

The protection is also temporary, lasting just 30 days post-listing. If the company's fundamentals or valuation are poor, the greenshoe option cannot prevent the stock from eventually dipping to its natural market price.

It is thus tailored to manage volatility and does not guarantee a premium listing and positive returns for investors. 

Greenshoe Option vs Over-Subscription

Let us look at the key differences between over-subscription and the Greenshoe option below: 

How Should Retail Investors Read a Greenshoe Clause

Here's how retail investors should read a greenshoe clause: 

• High-demand indicator: If underwriters exercise this option, it generally indicates robust market demand and that the share price is trading above the offer price. 
• Downside protection/safety: If the price falls below the IPO price, underwriters may buy back shares in the market to support the price. This offers an additional layer of protection for investors. 
• Finding necessary information: You should check the underwriting or basis-of-allotment section in the IPO prospectus. This includes all the details of the conditions and percentages when filed with regulators. 
• Stabilisation period: This is usually 30 days post-listing, meaning volatility may increase afterwards. 

Conclusion

The greenshoe option in IPO thus works as a mechanism to stabilise the stock price. Knowing more about the clause, how it works, and its impact on market prices is vital if you're an investor.