What is an IPO green shoe option?

Most of us who invest in stocks of a company know what is an IPO (initial public offering). An IPO is the first sale of a stock or share by a company to the public. Companies offering an IPO are sometimes new, young companies, or companies which have been around for many years and have finally decided to go public.

Before investing in an IPO, we go through the offer document of the company to know more about it. A listed company is legally bound to abide by commitments made in the document. Besides providing information about the company's competitive strengths, industry regulation, corporate structure, main objects, subsidiary details, risk factors, etc, the offer document also mentions a technical word called “Green shoe option”.

Let try to understand what does green shoe option mean.

Over-allotment option

• The green shoe option allows companies to intervene in the market to stabilise share prices during the 30-day stabilisation period immediately after listing. This involves purchase of equity shares from the market by the company-appointed agent in case the shares fall below issue price.
• The green shoe option is exercised by a company making a public issue. The issuer company uses green shoe option during IPO to ensure that the shares price on the stock exchanges does not fall below the issue price after issue of shares.
• Green shoe is a kind of option which is primarily used at the time of IPO or listing of any stock to ensure a successful opening price. Any company when decides to go public generally prefers the IPO route, which it does with the help of big investment bankers also called underwriters. These underwriters are responsible for making the public issue successful and find the buyers for company’s shares. They are paid a certain amount of commission to do this work.
• Green shoe option is a clause contained in the underwriting agreement of an IPO. The green shoe option is also often referred to as an over-allotment provision. It allows the underwriting syndicate to buy up to an additional 15% of the shares at the offering price if public demand for the shares exceeds expectations and the stock trades above its offering price.
• From an investor's perspective, an issue with green shoe option provides more probability of getting shares and also that post listing price may show relatively more stability as compared to market.

Origin of the Greenshoe

The term "greenshoe" came from the Green Shoe Manufacturing Company (now called Stride Rite Corporation), founded in 1919. It was the first company to implement the greenshoe clause into their underwriting agreement.

In a company prospectus, the legal term for the greenshoe is "over-allotment option", because in addition to the shares originally offered, shares are set aside for underwriters. This type of option is the only means permitted by the US Securities and Exchange Commission (SEC) for an underwriter to legally stabilise the price of a new issue after the offering price has been determined. The SEC introduced this option to enhance the efficiency and competitiveness of the fund raising process for IPOs.

Green shoe option in India

Green shoe options or over-allotment options were introduced by the Securities and Exchange Board of India (SEBI) in 2003 to stabilise the aftermarket price of shares issued in IPOs.

Guidelines for exercising green shoe option

• The guidelines require the promoter to lend his shares (not more than 15% of issue size) which is to be used for price stabilisation to be carried out by a stabilising agent (normally merchant banker or book runner) on behalf of the company.
• The stabilisation period can be up to 30 days from the date of allotment of shares to bring stability in post listing pricing of shares.
• After making the decision to go public, the company appoints underwriters to find the buyers for their issue. Sometimes, these underwriters also help the corporate in determining the issue price and the kind of equity dilution i.e. how many shares will be made available for the public.
• But with the turbulent times prevailing in the market place, it is however quite possible that the IPO undersubscribed and trades below its issue price.
• This is where these underwriters invoke the green shoe option to stabilise the issue.

How green shoe option works

• As said earlier, the entire process of a greenshoe option works on over-allotment of shares. For instance, a company plans to issue 1 lakh shares, but to use the greenshoe option; it actually issues 1.15 lakh shares, in which case the over-allotment would be 15,000 shares. Please note, the company does not issue any new shares for the over-allotment.
• The 15,000 shares used for the over-allotment are actually borrowed from the promoters with whom the stabilising agent signs a separate agreement. For the subscribers of a public issue, it makes no difference whether the company is allotting shares out of the freshly issued 1 lakh shares or from the 15,000 shares borrowed from the promoters.
• Once allotted, a share is just a share for an investor. For the company, however, the situation is totally different. The money received from the over-allotment is required to be kept in a separate bank account (i.e. escrow account)

Role of the stabilising agent

• The stabilising agent starts its process only after trading in the share starts at the stock exchanges.
• In case the shares are trading at a price lower than the offer price, the stabilising agent starts buying the shares by using the money lying in the separate bank account. In this manner, by buying the shares when others are selling, the stabilising agent tries to put the brakes on falling prices. The shares so bought from the market are handed over to the promoters from whom they were borrowed.
• In case the newly listed shares start trading at a price higher than the offer price, the stabilising agent does not buy any shares.

Greenshoe option in action

• It is very common for companies to offer the greenshoe option in their underwriting agreement. In 2009, most realty companies in India, who were planning to raise funds from the primary market, had opted for green shoe option in their IPOs to stem volatility in share prices following their listing on the exchanges.
• Companies such as Sahara Prime City, DB Realty, Lodha Developers and Ambience had opted for the green shoe option, which helped them stabilise share prices in the event of extreme volatility or prices moving below offer price.