Definition
A Greenshoe option refers to a provision in an underwriting agreement that allows the underwriter to sell more shares than initially planned by the issuer. This option helps the underwriting firm stabilize the initial price of a stock during its offering. It is named after the first company, Green Shoe Manufacturing, that utilized this type of option.
Key Takeaways
- The Greenshoe Option is a provision in an underwriting agreement that grants the underwriter the right to sell investors more shares than initially planned by the issuer if the demand for a security issue proves higher than expected.
- Greenshoe options typically allow underwriters to sell up to an additional 15% of the company’s shares, ensuring that the market is not flooded, therefore, maintaining the stock’s price.
- The name “Greenshoe” originated from the Green Shoe Manufacturing Company, which was the first to grant such an option to its underwriters in an IPO. It helps to stabilize the price of new issues, benefiting both issuers and investors.
Importance
The Greenshoe Option is a significant term in finance because it gives underwriters the authority to sell more shares than the initial amount set by the company during an Initial Public Offering (IPO) if the demand is high.
This option helps to stabilize the stock price as it permits the underwriter to oversell and then buy back shares at a later date.
This ability to control significant stock amounts reduces the risk of price volatility after the IPO, thus protecting both the company and its investors from potentially significant market disadvantages.
Hence, the Greenshoe Option plays a critical role in financial markets by promoting price stability and reassuring investor confidence.
Explanation
The primary purpose of a Greenshoe option is to stabilize the price of a security following its initial public offering (IPO). This option is a special provision in an IPO underwriting agreement, authorizing the underwriters to issue more shares to the public than initially planned by the issuer. This way, the underwriters have a certain level of control over post-IPO price fluctuations.
By having the ability to sell more shares than initially offered, they can counter any excessive upward movement in the price of the security due to excess demand. Greenshoe option is used by underwriters to prevent loss on their short position in case of high demand.
Under an over-allotment, the underwriters initially sell to investors more shares than have been issued by the company. If the price of the shares falls post IPO, they can then buy back the additional shares they sold at the lower price, removing the pressure off the price.
If the price rises, they can exercise the Greenshoe option, allowing them to buy from the issuer additional shares at the old, lower price, and then sell them to investors at the new, higher price. This stabilizes the stock’s price and benefits both the underwriters and investors.
Examples of Greenshoe Option
Facebook IPO: In Facebook’s 2012 IPO, the company’s underwriters used the Greenshoe option to sell more shares than initially declared, due to the high demand. Underwriters sold 421 million shares rather than the expected 337 million to meet the substantial market demand. This allowed them to raise additional capital and stabilize the share price after it started trading publicly.General Motors IPO: In November 2010, General Motors Co. went into the public market under colossal demand. Its underwriters purchased an additional
7 million shares, raising the total to 478 million and thereby increasing the IPO size from $8 billion to a staggering $
1 billion using the Greenshoe option.Alibaba Group Holding Limited IPO: The Chinese multinational conglomerate employed the option in its 2014 IPO, making it the world’s largest IPO then. Its underwriters, facing a swelling demand, exercised the Greenshoe option to purchase around 48 million additional shares, bringing the total capital gathered to $25 billion. This move helped stabilize the share price and meet investor demand.
Frequently Asked Questions about Greenshoe Option
1. What is a Greenshoe Option?
A Greenshoe Option is a clause contained in the underwriting agreement of an initial public offering (IPO), that allows underwriters to buy up to an additional 15% of company shares at the offering price for a certain period after the offering. This provides stability and liquidity to the share price after the listing.
2. Why is it called a “Greenshoe Option”?
The name “Greenshoe” originates from the Green Shoe Manufacturing Company, the first company to implement this type of option in an IPO. This process has become standard practice and is now implemented by most companies when they go public.
3. How does a Greenshoe Option work?
A Greenshoe option allows the underwriters of an IPO to sell more shares to investors than originally planned. If the IPO is successful and the share price rises, the underwriters exercise this option, buy back the additional shares at the lower IPO price, and then sell them at the current higher market price, making a profit.
4. What are the benefits of a Greenshoe Option?
A Greenshoe Option can provide stability to the market price of a new stock, avoiding large spikes and drops. By having the ability to sell additional shares, underwriters can satisfy excessive demand and potentially prevent a sharp price increase. In addition, if the stock price drops below the offering price, the underwriters can buy back shares to support the price.
5. Can a Greenshoe Option harm investors?
If improperly used, a Greenshoe Option could potentially harm investors. However, this provision is generally viewed as a protection mechanism for both the underwriters and investors. Any risks associated with a Greenshoe Option are typically outweighed by the benefits of price stability and increased liquidity.
Related Entrepreneurship Terms
- Initial Public Offering (IPO)
- Underwriting
- Over-Allotment
- Securities
- Stock Market
Sources for More Information
- Investopedia: A comprehensive resource dedicated to investing education equipped with a robust dictionary of financial and investment terms.
- NASDAQ: The official website of the NASDAQ stock market, which offers investment information, stock market news, and current financial news.
- Morningstar: A company that provides investment research and investment management services. It’s a good resource for detailed information on investments, including stocks, mutual funds, and exchange-traded funds.
- Corporate Finance Institute: An educational platform offering a wide range of resources for learning about financial topics. It hosts several finance courses, templates, articles, and other study materials.
