Greenshoe Option – Meaning, Types, Example and Benefits

The Indian stock market has witnessed many IPOs recently, with most of them generating huge listing gains. However, huge price increases can cause instability in the financial markets and attract new investors to buy shares near the top. Conversely, an IPO can perform poorly on the listing day, causing panic among investors. This is where the concept of a Greenshoe Option comes in. 

In this blog, we will walk you through the concept of the Greenshoe Option, its types and how it works.

What is the Greenshoe Option?

The term “Greenshoe option” is derived from Greenshoe Manufacturing, the first company to use this price stabilization mechanism during its IPO in 1960. It tackles the issue of excess demand for shares and prevents steep price increases once they are listed on a stock market. This option allows the investment banks or underwriters to sell more shares than initially intended, up to 15%. On the other hand, the Greenshoe option also allows underwriters to support the share price by repurchasing the shares at the proposed price if the IPO has not been fully subscribed. 

In 2003, the Securities and Exchange Board of India introduced this option for IPOs. The choice benefits the market, investors, underwriters, and businesses. With these choices, businesses can rest assured of their share’s performance on the listing day. This improves investor confidence and makes the IPO more appealing to potential investors. 

Types of Greenshoe Options

There are three types of Greenshoe options, and each one uses a unique method to keep prices stable: 

1. Full Greenshoe Option – In the event of high demand, the Full Greenshoe option allows underwriters to purchase an additional 15% of the shares originally offered from the issuer at the predetermined price. The underwriter then sells these shares in the market at a profit and tries to control the steep price rises. This also helps in increasing liquidity.

2. Partial Greenshoe Option – In this type, the underwriters can issue more than the shares initially offered but don’t issue the maximum number of shares permitted, i.e., 15%. The underwriters buy additional shares, less than 15% of the issue size, from the company and sell them in the stock market to control excess demand.

3. Reverse Greenshoe Option – The underwriters use this option to protect against sharp declines in share prices on the listing date. In this option, underwriters purchase the shares from the stock market and sell them back to the issuer company at the offer price. 

How Does the Greenshoe Option Work?

Below are the steps through which a Greenshoe option works-

1. Commitment of Underwriter – The underwriters decide to buy a certain number of shares from the firm that is issuing them at a specific price. 

2. Initial Public Offer – Following that, during the IPO process, the underwriter sells these shares to the general public. 

3. Demand for Shares – Following the listing, stock prices may rise with higher demand for the shares. 

4. Using the Greenshoe Option – The underwriters choose this option to stabilize the excessive price fluctuations because it enables them to buy more shares from the company at the initial issue price. These shares are then sold to the public, increasing the supply of shares and lowering prices.

Greenshoe Option Process

Below is a description of the entire Greenshoe option procedure.-

1. Agreement – To enable them to sell an extra 15% of the entire issue if demand for shares surpasses expectations, the firm issuing the shares appoints an underwriter and enters into a contract with them. 

2. Setting Conditions – In this phase, the business determines the IPO price and the quantity of shares to be distributed. 

3. Exercising the Greenshoe Option – Underwriters exercise the Greenshoe option and sell their 15% excess shares over the allotted size when the stock price increases; if the stock price falls, they repurchase shares from the market to make up for the over-allotment.

4. Price Stabilization – There will be a stabilization phase of 30 days after the company’s stock is listed on the exchange and trading starts, during which the underwriters watch the stock price. The underwriter sells more shares if the share price continues to be higher than the IPO price. 

Example of Greenshoe Option

Greenshoe options come in many forms, some of which are listed below-

1. Uber – Because of the extreme market volatility in 2019, Uber’s underwriter used the full Greenshoe option to stabilize the share after listing. 

2. Alibaba – Alibaba, a Chinese firm, launched one of the biggest initial public offerings (IPOs) ever in 2014. To handle the overwhelming demand for shares, the underwriters used the Greenshoe option. 

The aforementioned instances demonstrate that the Greenshoe option is a crucial instrument for controlling share price volatility to benefit investors and the business. 

Benefits of the Greenshoe Option

The major benefits of Greenshoe options are as follows –

1. Benefit for Issuing Companies – The major for companies issuing IPO and using the Greenshoe option are as follows-

• Price Stability – The business can keep its share price stable during the initial trading phase by using the Greenshoe option. 
• Reduces the Risk – The Greenshoe option assists the business in lowering the risk associated with a stock price correction. 
• Increase Capital – By choosing this option, the businesses can raise more money to finance their expansion. 
• Increase Investor Participation – A successful initial public offering (IPO) boosts investor trust and draws in additional investors. 

2. Benefits for Underwriters – The major benefits of the Greenshoe option for underwriters are as follows-

• Mitigation of Risk –They can support the share price by using the reverse Greenshoe option.
• High Profit – After the listing of shares, if the share prices rise, the underwriters can increase their profits by selling the additional shares at a higher price offered in the market.
• Goodwill – If an underwriter has a good reputation regarding post -IPO share price stabilization, more companies will appoint them as their underwriter, increasing their business.

Conclusion

To sum up, the underwriter uses the Greenshoe option as a key instrument to keep the price of shares stable after listing. This option allows underwriters to issue additional shares in the market to tackle excess demand, which controls sharp price increases. On the other hand, the option also allows them to purchase shares and sell them back to the issuer at the offer price to control sharp share price declines. A 15% limit is set under the Greenshoe option in India. Before making any investment decisions, you are advised to speak with your investment advisor.  

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