When a company decides to make its shares available to the public through an IPO, it typically engages the services of an investment bank, commonly referred to as an underwriter.
There is one term closely associated with the underwriter, and that is the Greenshoe Option. We will understand more about this option in detail – its process, why it is required, its importance, and also an example.
What is Greenshoe Option in an IPO?
The Greenshoe Option, also known as an over-allotment option, is a important aspect of an IPO.
In simple terms, it allows underwriters, who facilitate the IPO, to buy additional shares beyond the initially agreed amount. This option helps stabilize the stock price during the early days of trading.
If the demand for shares is high, the underwriters can use the Greenshoe to purchase more shares at the offering price, preventing the stock from soaring excessively.
Conversely, if the stock price drops below the offer price, the underwriters can buy back shares from the market to support the price.
Also Read : What is FACE Value in IPO and Why it is Important?
History of Greenshoe Option
The term “Greenshoe” traces its roots back to the Green Shoe Manufacturing Company, established in 1919 (now known as Stride Rite Corporation). This company pioneered the inclusion of the Greenshoe clause in its underwriting agreement.
The U.S. Securities and Exchange Commission (SEC) later embraced this option as a legitimate means for underwriters to stabilize new issue prices after determining the offering price.
Why Greenshoe Option is Important?
Following are some of the major benefits of Greenshoe option in an IPO,
1. Price Stabilization:
Market Volatility Mitigation: One of the primary roles of Greenshoe Options is to stabilize share prices in the volatile period following an IPO. By allowing underwriters to intervene in the market, it prevents drastic fluctuations in share prices.
Balancing Supply and Demand: Greenshoe Options help in balancing the supply and demand dynamics for newly issued shares. This equilibrium is crucial for maintaining a fair market value and preventing overvaluation or undervaluation.
2. Risk Management:
Protecting Underwriters: For underwriters responsible for facilitating the IPO, Greenshoe Options act as a risk management tool. In situations where the demand for shares is less than anticipated, or market conditions are unfavorable, underwriters can exercise this option to minimize losses.
3. Boosting Investor Confidence:
Assurance for Retail Investors: Greenshoe Options provide retail investors with a sense of security. Knowing that there is a mechanism in place to stabilize share prices post-listing reduces the risk of significant declines, offering a level of confidence to those entering the market.
4. Enhancing IPO Success:
Attracting Investor Participation: The presence of Greenshoe Options in an IPO can attract more investors. Knowing that there is a safety net to address potential market turbulence encourages participation, contributing to the overall success of the public offering.
5. Market Credibility:
Regulatory Recognition: Greenshoe Options are regulated by market authorities such as the Securities and Exchange Board of India (SEBI). Their inclusion in the IPO process adds a layer of credibility, signaling that the market is equipped to handle unforeseen circumstances.
6. Facilitating Price Discovery:
Efficient Price Determination: Greenshoe Options facilitate a more efficient price discovery process. By allowing underwriters to intervene and stabilize prices, the market can find a more accurate and reflective value for the newly listed shares.
7. Investor Protection:
Securing Retail Investor Interests: Greenshoe Options play a crucial role in protecting the interests of retail investors. The potential for stabilized prices in the initial days post-listing ensures that retail investors are less likely to experience abrupt and substantial losses.
How Does a Greenshoe Option Work?
The Greenshoe Option acts as a safety net during the 30-day stabilization period post-listing.
Underwriters, who facilitate the IPO process, are granted the privilege to short up to 15% of the issuer’s shares. This short position is established through an agreement where the issuing company compensates the underwriters with fees or commissions.
When the share prices experience a decline post-listing, underwriters strategically intervene by purchasing these shares from the market to cover their short position.
This buyback diminishes the supply of shares, causing the share price to rise. The increased demand resulting from the buyback ensures that the share price remains above its issue price, safeguarding investors from substantial losses.
Conversely, if the share price rises, underwriters can exercise their Greenshoe option to purchase an additional 15% of shares from the issuer at the offer price.
This process allows underwriters to cover their position without incurring significant losses and reinforces the stability of the stock.
For investors, the Greenshoe option provides a valuable assurance of price stability post-listing. It offers a layer of confidence that the share price is less likely to experience dramatic declines, making an IPO with a Greenshoe option an attractive prospect for those seeking a more secure investment.
What Are the Types of Greenshoe Options?
Greenshoe Options come in various forms: full, partial, and reverse. Each type serves a unique purpose in stabilizing share prices.
Greenshoe options come in three main types:
1. Full Greenshoe Option:
The underwriter repurchases the entire 15% of shares from the issuer, settling their market position with no profit or loss.
2. Partial Greenshoe Option:
The underwriter exercises the option to repurchase only a portion of the 15% shares, limiting profits as the bought-back portion is at the offer price.
3. Reverse Greenshoe Option:
The underwriter sells extra shares back to the issuing company, allowing them to review and manage their position and potentially realize profits.
These options provide underwriters with flexibility to navigate market dynamics and stabilize stock prices after an IPO, depending on factors like demand and price stability.
Greenshoe Option Process Guidelines
Regulations and guidelines govern the execution of Greenshoe Options. The market regulator, Securities and Exchange Board of India (SEBI) in India, plays a crucial role in framing these standards.
- Timeframe: The Greenshoe option is time-bound, allowing underwriters or stabilizing agents to intervene within 30 days from the IPO listing day.
- Limit on Overallotment: The overallotment is capped at 15% of the total shares initially offered, ensuring controlled market impact.
- Profit Handling: Profits generated through Greenshoe must be transparently deposited with the regulatory body, promoting ethical practices.
- Role of Underwriters: Underwriters act as stabilizing agents, making strategic decisions on when and how to exercise the option based on market conditions.
- Determining Offer Price and Equity Dilution: Underwriters assist in deciding the offer price and extent of equity dilution, aligning with market realities and financial goals.
- Stabilization Period: The Greenshoe option operates during the initial 30 days post-IPO, preventing excessive share price volatility.
- Transparency with Investors: Companies communicate Greenshoe strategy transparently in IPO documentation, instilling investor confidence and demonstrating commitment to stability.
How does it help retail investors?
The Greenshoe option significantly benefits retail investors by assuring price stability, mitigating downside risks, and instilling confidence in the post-IPO market.
With the assurance of stability in share prices, retail investors are less exposed to drastic falls, providing a sense of security.
The active buyback of shares by underwriters through the Greenshoe option, especially when prices dip below the offer price, serves to mitigate downside risks, ensuring that investments remain relatively stable.
Moreover, the presence of the Greenshoe option enhances investor confidence. Retail investors appreciate the transparent and proactive approach taken by companies and underwriters to manage potential fluctuations, making the IPO more attractive.
The option provides a secure exit within the first 30 days, aligning with retail investors’ preferences for a reliable investment exit strategy.
By preventing sharp declines in stock prices, the Greenshoe option safeguards retail investors’ investments and contributes to the overall credibility of the IPO.
Green shoe option in India – Example
In 2003, SEBI introduced Greenshoe Options to stabilize the aftermarket price of shares issued in IPOs.
In the 2017 IPO of Avenue Supermarts, the parent company of D-Mart, the Greenshoe option played a important role in managing market dynamics.
Setting the offer price at Rs. 299 per share, Avenue Supermarts incorporated the Greenshoe option, allowing underwriters to allot an additional 15% of shares if needed.
Post-listing, the stock witnessed strong demand, prompting the partial exercise of the Greenshoe option.
This strategic move helped underwriters purchase extra shares at the offer price, stabilizing the trading price and ensuring a controlled market response
Also Read : What happens when an IPO is Oversubscribed – How the shares are allotted?
Conclusion
In summary, the Greenshoe Option is a powerful tool that helps keep stock prices steady and boosts investors’ confidence.
FAQs about Greenshoe Option in IPO
Q1: What is the Greenshoe Option in an IPO?
Answer: The Greenshoe Option, or over-allotment option, allows underwriters to buy additional shares beyond the initially agreed-upon amount during an IPO. It helps stabilize stock prices in the market.
Q2: How does the Greenshoe Option work?
Answer: Underwriters use the Greenshoe Option to purchase extra shares at the offering price if the demand is high. This stabilizes the stock price. If the price falls, they can buy back shares from the market to support it.
Q3: Why is the Greenshoe Option important?
Answer: The Greenshoe Option ensures a smoother market debut for newly listed stocks, preventing excessive price volatility. It instills confidence in investors by maintaining stability in the stock’s initial trading days.
Q4: What is the history behind the term “Greenshoe”?
Answer: The term “Greenshoe” originated from a shoe company that first used this option in its IPO in 1919. It has since become a standard practice in the IPO process.
Q5: Can you provide an example of the Greenshoe Option in action?
Answer: Certainly, one notable example is the Avenue Supermarts IPO (2017), where the Greenshoe Option was strategically used to stabilize the stock price of D-Mart after listing.
Q6: Are there guidelines for the Greenshoe Option process?
Answer: Yes, the Greenshoe Option can be exercised within 30 days of the IPO date. The issuing company can lend up to 15% of the total offer amount for price stabilization.
Q7: How does the Greenshoe Option benefit retail investors?
Answer: Retail investors benefit from the Greenshoe Option as it provides assurance of price stability post-listing, making it a valuable feature in IPO contracts.
Q8: Is the Greenshoe Option applicable in the Indian market?
Answer: Yes, the Securities and Exchange Board of India (SEBI) introduced the Greenshoe Option in 2003 to stabilize aftermarket prices of shares issued in IPOs.
Q9: Can underwriters partially exercise the Greenshoe Option?
Answer: Yes, underwriters have the flexibility to partially exercise the Greenshoe Option, acquiring back all or a portion of the shares based on market conditions.
Q10: How does the Greenshoe Option contribute to overall market efficiency?
Answer: The Greenshoe Option enhances market efficiency by preventing excessive price fluctuations, maintaining a balance between supply and demand, and ensuring a controlled post-listing environment.
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