Greenshoe Option

A greenshoe option, formally an over-allotment option, is a clause in an underwriting agreement that gives the underwriters of a share offering the right to buy additional shares at the offer price for a limited period after the offering. It is typically set at up to 15 per cent of the number of shares offered and can usually be exercised within 30 days. The option allows the underwriters to sell more shares than the base offering and then to cover that extra sale in whichever way suits market conditions.

The device is a standard feature of an initial public offering and of many follow-on offerings. Its name comes from the Green Shoe Manufacturing Company, a US footwear maker whose share offering is credited as the first to include it. It is the main tool of the stabilisation mechanism by which underwriters support the price of newly issued shares.

At pricing, the underwriting syndicate allocates to investors more shares than the issuer is selling in the base deal, typically 115 per cent of it. The extra shares are borrowed, usually from a large existing shareholder under a stock lending agreement, so that all investors receive shares on the settlement date. The syndicate is therefore short the over-allotted shares, and one bank, the stabilising manager, manages that position.

What happens next depends on the share price.

• Price rises above the offer price. Buying shares in the market to return to the lender would cost more than the offer price. The stabilising manager instead exercises the greenshoe, buys the extra shares from the issuer or selling shareholders at the offer price, and uses them to close the short. The offering ends up larger by the amount exercised.
• Price falls below the offer price. The stabilising manager buys shares in the market at or below the offer price and uses them to close the short. These purchases provide demand that supports the price. The option lapses unexercised and the offering stays at its base size.
• Mixed outcome. The manager may cover part of the short in the market and exercise the option for the rest.

Without the option, covering a short position after a price rise would expose the underwriters to a loss. With it, the short position carries no price risk on the upside, which is what makes over-allotment practical.

In the standard form the short is covered by the option, sometimes called a covered short. Underwriters may also sell beyond the amount of the option, creating a naked short that can only be closed by market purchases. A reverse greenshoe works the other way: the underwriters hold a put option allowing them to sell shares back to the issuer or a shareholder, having bought them in the market to support the price. The option shares may be new shares issued by the company, which brings in additional capital, or existing shares from selling holders, which does not.

Buying shares to support a price would ordinarily raise concerns about market manipulation, so stabilisation is permitted only within defined limits. In the United States, Regulation M governs stabilising bids and syndicate covering transactions, and the 15 per cent ceiling on the over-allotment option reflects rules of the Financial Industry Regulatory Authority. In the European Union and the United Kingdom, the market abuse regime provides a safe harbour for stabilisation that meets set conditions: it must be limited in time, generally 30 calendar days from the start of trading for an initial offering, it must not be carried out above the offer price, and the greenshoe may not exceed 15 per cent of the original offer.

The existence and size of the option, the identity of the stabilising manager and the stabilisation period are disclosed in the prospectus. After the period ends, the market is told whether stabilisation took place and how far the option was exercised.

The option gives issuers and sellers a way to place more shares when demand is strong, and gives new investors some comfort that the price will be supported in early trading, when a lock-up restricts sales by existing holders and the shareholder base is still forming. It benefits underwriters as well: fees are earned on the option shares if it is exercised, and if the price falls the syndicate profits from covering its short below the offer price.

Critics note that this profit creates a conflict, since the stabilising manager gains when the offering trades poorly, and that support is temporary: once the short is covered, the buying stops. Research on IPO allocation and pricing has also linked over-allotment to the tendency for offerings to be priced below the level at which they first trade. Stabilisation cannot hold up a badly received deal; several large offerings have fallen well below their offer price despite full use of the over-allotment position. The related processes of book building and primary market issuance determine how much support is likely to be needed.