The greenshoe option allows underwriters involved with IPOs to sell more shares than initially agreed upon: usually up to 15% more. That can occur if there is enough investor demand to purchase the shares.
Because IPO share prices can be volatile, the greenshoe option is an important tool that can help underwriters stabilize the price of a newly listed stock to protect both the company and investors.
Understanding the Greenshoe Option
Also called the over-allotment option, the greenshoe provision is part of an underwriting agreement between an underwriter and a company issuing stock as part of an IPO, or initial public offering. The greenshoe option is the only type of price stabilization allowed by the Securities and Exchange Commission (SEC).
The SEC allows this because it increases competitiveness and efficiency of IPO fundraising. It gives underwriters the ability to stabilize security prices by increasing the available supply. It is the responsibility of an underwriter to help sell shares, build a market for a new stock, and use the tools at their disposal to launch a successful initial public offering.
The greenshoe option got its name when the Green Shoe Manufacturing Company was issued the first over-allotment options in 1919.
💡 Quick Tip: Access to IPO shares before they trade on public exchanges has usually been available only to large institutional investors. That’s changing now, and some brokerages offer pre-listing IPO investing to qualified investors.
How Does a Greenshoe Option Work?
During the IPO process, stock issuers set limits on how many shares they will sell to investors during an IPO. With a greenshoe option, the IPO underwriter can sell up to 15% more shares than the set amount.
IPO underwriters want to sell as many shares as they can because they earn on commission as a percentage of IPO sales.
All of the details about an IPO sale and underwriter abilities appear in the prospectus filed by the issuing company before the sale. Not every company allows their investment banker to use the greenshoe option. For instance, if they only want to raise a specific amount of capital, they wouldn’t want to sell any more shares than necessary to raise that money.
There are two ways an underwriter can over allot sales:
At the IPO Price
If the IPO they are underwriting is doing well, investors are buying IPO shares and the price is going up, the underwriter can use the greenshoe option to purchase up to 15% more stock from the issuing company at the IPO price and sell that stock to investors at the higher market price for a profit.
A Break Issue
Conversely, if an IPO isn’t doing well, the underwriter can take a short position on up to 15% of the issued stock and buy back shares from the market to stabilize the price and cover their position.
The underwriter then returns those additional shares to the issuing company. This is known as a “break issue.” When an IPO isn’t performing well, this can reduce consumer confidence in the stock, and result in investors either selling their shares or refraining from buying them.
The greenshoe option helps the underwriter stabilize the stock price and reduce stock volatility.
Types of Greenshoe Options
There are three types of greenshoe options an underwriter might choose to use depending on what happens after an IPO launches. These options are:
Full Greenshoe
If the underwriter can’t buy back any shares before the stock price increases, this is known as a full greenshoe. In this case, the underwriter buys shares at the current offering price.
Partial Greenshoe
In a partial greenshoe scenario, the underwriter only buys back some of the stock inventory they started with in order to increase the share price.
Reverse Greenshoe
The third option for underwriters is to purchase shares from market investors and sell them back to the stock issuer if the share price has dipped below the original offering price. This is similar to a put option in stock trading.
Recommended: How Are IPO Prices Set?
Greenshoe Option Examples
Here’s an example of how a greenshoe option might work in real life.
Once the IPO company owners, underwriter, and clients determine the offering or initial price of the newly issued shares, they’re ready to be traded on the public market. Ideally, the share price will rise above offering, but if the shares fall below the offering price the underwriter can exercise the greenshoe option (assuming the company had approved it in the prospectus).
To control the price, the underwrite can short up to 15% more shares than were part of the original IPO offering.
Let’s say a company’s initial public offering is going to be 10 million shares. The underwriters can sell up to 15% over that amount, or 1.5 million more shares, thus giving underwriters the ability to increase or decrease the supply as needed — adding to liquidity and helping to control price stability.
💡 Quick Tip: Investment fees are assessed in different ways, including trading costs, account management fees, and possibly broker commissions. When you set up an investment account, be sure to get the exact breakdown of your “all-in costs” so you know what you’re paying.
What the Greenshoe Option Means for IPO Investors
The greenshoe option is an important tool for underwriters that can help with the success of an IPO and bring additional funds to the issuing company. It reduces risk for the issuing company as well as investors. It can maintain IPO investor confidence in a newly issued stock which helps to build a long-term group of shareholders.
Although buying IPO stocks can be very profitable, stock prices don’t always increase and sometimes they can be volatile. It’s important for investors to research a company, look at the IPO prospectus, understand what the stock lock-up period and greenshoe options are before deciding to buy.
The Takeaway
Buying shares in IPOs can be a great way to invest in companies right when they go public. Although IPO investing comes with some risks, and IPO stock can be volatile, investment banks and companies going public use tools such as the greenshoe option to minimize volatility.
Whether you’re curious about exploring IPOs, or interested in traditional stocks and exchange-traded funds (ETFs), you can get started by opening an account on the SoFi Invest® brokerage platform. On SoFi Invest, eligible SoFi members have the opportunity to trade IPO shares, and there are no account minimums for those with an Active Investing account. As with any investment, it's wise to consider your overall portfolio goals in order to assess whether IPO investing is right for you, given the risks of volatility and loss.
Photo credit: iStock/AzmanJaka
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