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Over-Allotment Option/Greenshoe Option: Understanding the Use and Benefit of this Powerful Financial Tool

An over-allotment option is understood by relatively few people, despite its important role in capital markets and the stock market. This type of option allows companies to issue extra shares of their stocks beyond those that they initially planned or announced when they go public (or offer other securities). It’s also known as a “greenshoe option”, referring to the brand of shoes that are now part of Wolverine Worldwide and was first used by underwriters back in the 1970s for issuing additional shares. But how exactly does it work? In this post, we’ll explore what this type of option is and how it works so that you can have a better understanding of this powerful, financial planning tool.

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To learn more about other terms commonly used in venture capital,Β check out our complete VC Glossary.

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This type of option allows companies to issue extra shares of their stocks beyond those that they initially planned or announced when they go public (or offer other securities). It's also known as a "greenshoe option".

Takeaway:

  • Over-allotment options are a great way for companies to raise additional capital, provide price stability and liquidity, cover short positions in the event of a fall in prices, and avoid purchasing shares if the price goes up. They are an important financial tool that can be used to adjust the issue size of securities based on market conditions.

What is the over-allotment option?

This option (sometimes called a “greenshoe option”) is available to underwriters to sell additional shares in an Initial Public Offering (IPO).

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Underwriters can sell up to 15% more shares than they initially agreed to, but this option must be exercised within 30 calendar days of the initial public offering.

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The IPO underwriting agreement between an issuing company and its underwriters contains the over-allotment option details. If the share price falls or demand is more significant than expected, the brokerage agencies can exercise the greenshoe option. It is the only type of price stabilization measure permitted by the Securities and Exchange Commission (SEC).

How the Greenshoe, or Over-Allotment, Option works

Over-allotment options are also known as “greenshoe options” because, in 1919, Green Shoe Manufacturing Company (now part of Wolverine Worldwide, Inc. ) was the first to offer this option. A greenshoe option adds price stability to security issues because the underwriter can increase the supply and smooth out fluctuations.

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Greenshoe options allow underwriters to sell up to 15% more shares than originally agreed upon by the issuer. For instance, if a company orders underwriters to sell 100 million shares, an additional 15,000,000 shares can be issued through the exercise of a greenshoe choice.

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The underwriters are incentivized to make the IPO as successful as possible since their commission is a percentage of it. The company files a prospectus with the SEC prior to an IPO, outlining the actual percentage and conditions of the offering.

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There are one of two ways underwriters use greenshoe options: One, if the IPO goes well and shares are selling quickly, the underwriters can exercise their option and buy additional stock from the company at a predetermined price and then issue the shares to their clients at a profit. Two, if the shares fall to below the issuing price, the underwriters will buy back shares from the market to support the stock’s stability.

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Under certain circumstances, some issuers do not want to include greenshoe options as part of their underwriting agreements. For example, if they are looking to fund a project with a fixed amount and have no need for additional capital.

Greenshoe Option Examples

One of the most notable examples of a greenshoe option being exercised is from 2018, when Jack Ma’s investment bank Ant Financial raised $14 billion through its IPO. The company opted to include a greenshoe option as part of their underwriting agreement. This allowed Ant Financial to increase the total amount of money that they could raise from investors by up to 15%, or $2.1 billion.

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Another example is the highly successful IPO of Saudi Aramco, which was the world’s largest with a total valuation of $29.4 billion. The company opted to use an over-allotment option as part of their underwriting agreement but did not need to exercise it as demand for their shares exceeded expectations and the IPO was oversubscribed.

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Overall, greenshoe options are a great way for companies to raise additional capital and provide price stability and liquidity. They can offer the buying power to cover short positions in the event of a fall in prices and the ability to avoid purchasing shares if the price goes up. With their use of greenshoe options, companies have the flexibility to adjust their issues size based on market conditions. Investors investment banks and underwriters alike can benefit from this powerful financial tool.

Full, partial, and reverse Greenshoe

An underwriter can choose to use a partial or a full greenshoe. A partial greenshoe option means that the underwriter buys back only a portion of the shares before they rise in price. A full greenshoe option sounds exactly like it: The underwriter exercises its full option to purchase additional shares at the IPO price.

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Reverse greenshoe option gives the underwriter the option to sell shares to the issuer at a later time. It helps to stabilize the stock’s price even in times of declining demand after an IPO. The option is exercised by the underwriter, who buys back shares from the market and then sells them to the issuer at a lower price. Companies use this technique to stabilize stock prices when there is increasing or decreasing demand.

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SEC Regulations on Over-allotment

Underwriters can engage in naked short selling in a share offering, according to the Securities and Exchange Commission (SEC). Short selling is a technique used by underwriters to anticipate a fall in prices. However, this practice can expose them to price rises as a risk.Β US underwriters short-sell the offering to stabilize pricesΒ and purchase it in the aftermarket. Although selling short puts downward pressure on stock prices, it may lead to higher price and a more stable and better stock offering.

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The SEC ended the practice of “abusive naked selling” during IPO operations in 2008. Naked short selling was a method of influencing stock price movements. This practice gave the impression a company’s shares were trading very actively. However, there were only a few market players manipulating price movements.

Bottom line

A greenshoe option, which can be included in an underwriting agreement, allows the underwriters of initial public offerings to have some control over the prices. The underwriter may sell an additional 15% or all of the shares if the secondary market price for IPO stock is higher than the IPO price. A reverse greenshoe option can also be used to support falling values.

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Ultimately, greenshoe options are a useful tool for IPO underwriters to ensure pricing stability and increase the chance of success for IPOs. As long as they abide by SEC regulations, these options can help underwriters maximize their profits while providing issuers with the capital needed to fund their projects. Β With this information in hand, you should have a better understanding of the role greenshoe options can play in a successful IPO. Β 

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