Because the newly issued stock in a company that has just completed an initial public offering (IPO) can be volatile, there may be a provision that grants underwriters a so-called greenshoe option. This allows them to sell additional shares to increase liquidity and stabilize the share price.
The greenshoe option allows underwriters involved with IPOs to sell up to 15% more shares. That can occur if there is enough investor demand to purchase the shares.
The greenshoe option is an important tool that can help underwriters manage the price of a newly listed stock to protect both the company and investors.
Table of Contents
Key Points
• The greenshoe option, also known as the over-allotment option, allows underwriters in an IPO to sell up to 15% more shares than the original offering.
• The primary function of the greenshoe option is to help underwriters stabilize the share price of a newly listed stock following the IPO.
• The Securities and Exchange Commission (SEC) permits this option as the only type of price stabilization because it increases the competitiveness and efficiency of IPO fundraising.
• If investor demand is strong and the share price rises, the underwriter can exercise a full greenshoe to buy the extra shares from the company at the IPO price to sell for a profit.
• If the stock price falls, the underwriter can take a short position on over-allotted shares and buy them back from the market, known as a “break issue,” to reduce volatility and stabilize the price.
Understanding the Greenshoe Option
Also called the over-allotment option, the greenshoe provision is a clause in the agreement between an underwriter and a company issuing stock as part of an IPO, or initial public offering.
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 is the only type of price stabilization allowed by the Securities and Exchange Commission (SEC).
The SEC allows this option because it increases the competitiveness and efficiency of IPO fundraising. It gives underwriters the ability to stabilize share prices for those investing in stocks that have IPO’d by increasing the available supply.
The greenshoe option got its name when the Green Shoe Manufacturing Company was issued the first over-allotment options in 1919.
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, either via an online investing platform or a traditional brokerage:
Potential for More Profit
If the IPO they are underwriting is doing well, and 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.
Stabilizing the Price
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 are:
Full Greenshoe
A full greenshoe, as it sounds, allows underwriters to exercise the entire over-allotment of shares, which allows them to buy 15% more shares than the initial offering, and sell them at the IPO price to satisfy investor demand.
Partial Greenshoe
A partial greenshoe allows the underwriter to buy some of the over-allotment shares and sell enough to moderate market demand. A partial greenshoe provides some flexibility for price stabilization.
Reverse Greenshoe
When the IPO shares are seeing weak demand from investors, and/or the stock price falls below the initial offering, the underwriter can conduct what’s known as a reverse greenshoe. Here, the underwriter buys shares at the market price and sells them back to the company, ideally creating some demand and preventing a price drop.
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 the offering price, 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 underwriter 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.
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 interested in self-directed investing. 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 offer a 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 may 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.
FAQ
Who decides whether to use the greenshoe option?
The bank underwriters involved in the IPO decide whether to use the greenshoe option, assuming it’s available.
Are there risks to using the greenshoe option?
The risk of using the greenshoe option is that the underwriters might overestimate investor interest, and by selling more shares they might unintentionally drive down the share post-IPO share price.
Is there a time limit for the greenshoe option?
Typically, underwriters have 30 days after the initial public offering in which to exercise the greenshoe option.
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Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of losing principal. Key risks include, but are not limited to, unproven management, significant company debt, and lack of operating history. For a comprehensive discussion of these risks, please refer to SoFi Securities' IPO Risk Disclosure Statement. This is not a recommendation. Investors must carefully read the offering prospectus to determine if an offering is consistent with their objectives, risk tolerance, and financial situation. New offerings often have high demand and limited shares. Many investors may receive no shares, and any allocations may be significantly smaller than the shares requested in their initial offer (Indication of Interest). For more information on the allocation process, please visit IPO Allocation Procedures.
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