Green Shoe Options

Green Shoe Options

In the ever-evolving landscape of finance and investment, it is crucial to stay informed about various financial instruments. One such instrument that has gained significant popularity is the Green Shoe option. Green Shoe options play a vital role in the IPO process, benefiting both issuing companies and underwriters. By providing flexibility and stabilising stock prices, Green Shoe options enhance investor confidence, reduce risks, and maintain market equilibrium. Understanding this financial term equips investors and businesses alike with valuable knowledge in navigating the ever-changing world of finance. 

What are green shoe options? 

Green shoe options, also known as over-allotment options, are provisions included in the underwriting agreement between an issuing company and its underwriter during an initial public offering, or IPO. These options grant the underwriter the right to issue additional shares to meet excess demand in the market. 

The name “green shoe” originated from the Green Shoe Manufacturing Company, which was the first company to utilise this mechanism in the 1960s. The US Securities and Exchange Commission, or SEC, later formalised the concept as a means to stabilise volatile IPO markets. 

Understanding green shoe options 

When a company decides to go public through an IPO, it partners with an underwriter who assists in the offering process. The underwriter’s role is to facilitate the sale of the company’s shares to investors. To mitigate the risk of under-pricing or oversubscription, the underwriter and the issuing company may include a green shoe option in the underwriting agreement. 

The green shoe option allows the underwriter to sell additional shares, usually up to 15% of the original offering, within a specified time frame, typically 30 days after the IPO. This option helps balance supply and demand, ensuring price stability and preventing extreme fluctuations in the stock’s value during its initial trading period. 

Green shoe options provide a mechanism to address excess demand during IPOs, contributing to market stability and optimising the offering process for both issuing companies and underwriters. 

Working of green shoe options 

Once the IPO is complete, the underwriter observes the stock’s performance in the market. If the demand for the stock exceeds the available supply, the underwriter exercises the green shoe option. This involves purchasing additional shares from the issuing company at the offering price and subsequently selling them to investors at the prevailing market price. 

By exercising the green shoe option, the underwriter increases the supply of shares, satisfying the excess demand. This helps prevent rapid price appreciation and ensures a more stable market for the newly listed stock. The additional proceeds generated from the sale of these additional shares are typically shared between the underwriter and the issuing company. 

Advantages of green shoe options 

1. Price stabilisation: One of the primary advantages of green shoe options is their ability to stabilise the price of newly listed stocks. By providing the underwriter with the option to release additional shares, the demand-supply equilibrium is maintained, avoiding sudden price spikes or plunges.
2. Mitigation of Risk: Green shoe options offer a level of protection to underwriters by allowing them to manage the risks associated with IPOs. The additional shares can be utilised to offset the risk of being caught in an oversubscribed or undersubscribed scenario.
3. Enhanced Investor Confidence: Green shoe options instill confidence among investors by signalling that there is a mechanism in place to manage potential market volatility. This confidence can attract more investors to participate in IPOs.
4. Flexibility for Issuers: For issuing companies, green shoe options provide flexibility in adjusting the number of shares available for purchase. If demand is high, the option can be exercised to meet this demand. Conversely, if demand is lower than anticipated, the option can be left unexercised, ensuring the issuing company does not have to issue more shares than necessary. 

Example of green shoe options 

Let’s consider a hypothetical example to better understand how green shoe options work. Company XYZ, an emerging technology firm, plans to go public through an IPO. The underwriter agrees to include a green shoe option in the underwriting agreement. 

Initially, Company XYZ offers 10 million shares at a price of US$10 per share, aiming to raise US$100 million. The underwriter exercises the green shoe option, allowing it to purchase an additional 1.5 million shares from Company XYZ. Subsequently, these shares are sold to interested investors in the market. 

If the market price rises to US$12 per share, the underwriter generates additional proceeds of US$3 million (US$12 per share – US$10 per share x 1.5 million shares). This additional revenue is divided between the underwriter and Company XYZ according to their pre-determined agreement. 

Frequently Asked Questions