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What is the Greenshoe used in IPOs?

How does the Greenshoe work in an IPO and what is it?

The name "Greenshoe" arises from the Green Shoe Manufacturing Company (now called Stride Rite). It was the first company to use the Greenshoe in an IPO. The legal name is "overallotment option" from the fact that in addition to the shares intended to be offered, additional shares are set aside for the underwriters. This type of option is the only SEC-sanctioned method for an underwriter to legally stabilize a new issue stock after the offering price has been determined. 
The SEC allowed this option to enhance the efficiency and competitiveness of the IPO fundraising process, and it is only allowed for Full Commit underwritten IPOs - which are generally only offered by underwriters for larger scale IPOs. Small S-1 IPOs and Reg A+ IPOs which are small because they are limited to $50 mill, are usually made via Best Efforts underwritings, for which the SEC does not allow the use of the Greenshoe.

Price Stabilization

This is how a greenshoe option works:

The underwriter acts as a liaison, finding buyers for their client's newly-issued shares.
Sellers (company management) and buyers (underwriters and clients) determine a share price.
Once the share price is determined, they're ready to trade publicly. The underwriter then uses all legal means to keep the share price above the offering price.
If the underwriter finds there's a possibility that shares will fall below the offering price, they can exercise the greenshoe option.
In order to keep pricing control, the underwriter oversells or shorts up to 15% more shares than initially offered by the company.

For example, if a company decides to sell 1 million shares to the public, the underwriters can exercise its 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. This enables underwriters to stabilize fluctuating share prices by increasing or decreasing the supply according to initial public demand.

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 buyback shares at the offering price, thus protecting them their interests.

If a public offering trades below the offering price, it's referred to as a "broken issue." This can generate a general 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 situation, underwriters exercise their option and buy back shares at the offering price, returning those shares to the lender (issuer).

Full, Partial and Reverse Greenshoes

The number of shares the underwriter buys back determines if they will exercise a partial greenshoe or a full greenshoe. A partial greenshoe indicates that underwriters are only able to buy back some inventory before the share price rises. A full greenshoe occurs when they're unable to buy back any shares before the share price rises. The underwriter exercises the full option when that happens and buy at the offering price. The greenshoe option can be exercised at any time in the first 30 days after the offering.

The Bottom Line

The greenshoe option reduces the risk for a company issuing new shares, allowing the underwriter to have buying power in order to cover short positions if the share price falls, without the risk of having to buy shares if the price rises. In return, this keeps the share price stable, benefiting both issuers and investors.

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