A provision contained in an underwriting agreement that
gives the underwriter the right to sell investors more shares than originally
planned by the issuer. This would normally be done if the demand
for a security issue proves higher than expected. Legally referred to as an
over-allotment option.
A green shoe option can provide additional price stability to
a security issue because the underwriter has the ability to increase
supply and smooth out price fluctuations
if demand surges.
The mechanism by which the greenshoe option works to provide
stability and liquidity to
a public offering is described in the following example: A company intends to
sell one million shares of its stock in a public offering through an investment
banking firm (or group of firms which are known as the syndicate) whom the company has chosen
to be the offering's underwriter(s). When the stock is being offered for public
trading for the first time, the offering is called an Initial Public
Offering (IPO). When the stock is already
trading publicly and the company is simply selling more of their non-publicly
traded stock, it is called a follow
on.
The underwriters function as the broker of these shares
and find buyers among their clients. A price for the shares is determined by
agreement between the company and the buyers. When shares begin trading in a
public market, the lead underwriter is responsible for helping to ensure that
the shares trade at or above the offering price.
When a public offering trades below its offering price, the
offering is said to have "broke issue" or "broke syndicate
bid". This creates the perception of an unstable or undesirable offering,
which can lead to further selling and hesitant buying of the shares. To manage
this possible situation, the underwriter initially oversells (shorts) to their
clients the offering by an additional 15% of the offering size. In this example
the underwriter would sell 1.15 million shares of stock to its clients. When
the offering is priced and those 1.15 million shares are "effective"
(become eligible for public trading), the underwriter is able to support and
stabilize the offering price bid (which is also known as the "syndicate
bid") by buying back the extra 15% of shares (150,000 shares in this
example) in the market at or below the offer price. They can do this without
the market risk of being "long" this extra 15% of shares in their own
account, as they are simply "covering" (closing out) their short
position.
When the offering is successful,
demand for shares causes the price of the stock to go up and remain above the
offering price. If the underwriter were to close their short position by
purchasing shares in the open market then the underwriter would incur a loss by
purchasing shares at a higher price than the price at which they sold them
short.
This is where the over-allotment
(greenshoe) option comes into play: the company granted the underwriters the
option to purchase from the company up to 15% more shares than the original
offering size, at the original offering price. By
exercising their greenshoe option, the underwriters are able to close their
short position by purchasing shares at the same price for which they sold-short
the shares, so the underwriters do not lose money. If the underwriters are able
to buy back all of the oversold shares at or below the offering price (to
support the stock price), then they would not need to exercise any portion of
their greenshoe option. If they are able to buy back only some of the shares at
or below the offer price (because the stock eventually goes higher than the
offer price), then the underwriters would exercise a portion of greenshoe
option to cover their remaining short position. If the underwriters were not
able to buy back any portion of the oversold shares at or below the offering
price ("syndicate bid") because the stock immediately went and stayed
up, then they would completely cover their 15% short position by exercising
100% of their greenshoe option
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