If you are someone who follows the equities markets with interest, you must be familiar with the concept of initial public offerings of IPOs. An IPO is a market event that allows a company that allows a company to offer a certain portion of its shares to institutional and retail investors for infusing fresh capital in the company. IPOs are a great way for investors to pick up quality stocks and hence are keenly watched by the market. Before an IPO a company issues an offer document that lists the terms and conditions of the offering. The offer document provides a wealth of information to the informed investor about a number of factors such as the risk factors, the company’s corporate and subsidiary structure, the company’s strengths, and objectives, etc.  It is important for an investor to be able to understand the offer document before investing in the IPO. However, this is easier said than done as the document is often couched in financial jargon and difficult to understand terms. An important term often found in such offer documents which investors ponder about is greenshoe shares or greenshoe option. What is a greenshoe option and why does it matter to the IPO? To understand this it is first important to understand the IPO process and what is an underwriter.

The Underwriter and Greenshoe Shares

When a company decides to tap the capital markets for an IPO, it employs the services of a bank or group of banks called an underwriter. The job of the underwriter is to find buyers for the company’s shares at the offer price fixed by the company. Once the underwriter has offered the company’s shares for sale in the market, two things may happen:

1. The shares have been bought at or above the offer price set by the company. This is a positive outcome for the company as it indicates that there is a demand for the company’s shares.

2. The shares are bought at a price lower than the offer price. This is an undesirable outcome as it creates the perception that the company’s shares are not in demand, and can further lead to a fall in share price as the new buyers may want to offload the newly-bought shares to cut their losses.

The second scenario is where the greenshoe option process kicks in. It is essentially an intervention mechanism by the underwriter to buy back a certain portion of the company’s shares in order to shore up falling prices.

What is a Greenshoe Option?

Simply put, a greenshoe option is an option exercised by the underwriter to buy back a certain number of company’s shares at a fixed price to shore up the share price without risking any of its own capital. The underwriter is able to do so because, at the time of the IPO, the company issues an additional 15% shares to the underwriter solely for the purpose of risk management in case of the share price falling below the offer price post-listing. The underwriter shorts these shares only to buy them back later at the same price that it shorted them. In case the price of the scrip goes up, the underwriter can buy them back at the same price, thereby exiting its position at no-profit no-loss. This special privilege allowing the underwriter to buy back the shares at the offer price only is called the greenshoe option. If however, the price drops below the offer price, the underwriter buys back the shares at the market price. This large buying action by the underwriter causes the prices of the stock to rise. The underwriter also makes a per share gain equal to the fall in the share price post-listing. The greenshoe option process becomes more clear using the following example:

1. The company issues its stock for sale via the underwriter at Rs 10 per share. The underwriter sells 115% of the stock at the offer prices.  This in effect means that the underwriter is 15% short.

2. The price falls to Rs. 8 post-listing. The underwriter does not exercise the greenshoe shares option and buys the stock back at Rs. 8. This buying action shores the price of the stock. The underwriter makes a gain of Rs. 2 per share.

3. In case the price goes up to Rs. 12, the underwriter exercises the greenshoe shares option which grants him the privilege to buy back the shares at Rs. 10 only when in fact the market price is Rs. 12.

Guidelines for the Greenshoe Option Process

1. The issuing company can only lend 15% shares out of the total offer size for the greenshoe option process.

2. The underwriter or the stabilizing agent can exercise the greenshoe share option only within 30 days of the date of IPO.

3. The underwriter may invoke the greenshoe share option either in part or in full, i.e. the underwriter can buy back either all or a part of the shares as part of the greenshoe share option depending on the price action of the underlying stock relative to the offer price.

Importance of the Greenshoe Share Option

If the IPO document mentions that the company has an arrangement with its underwriter for the greenshoe option process, it instills confidence in the buyers that the company’s share is not likely to fall much below the offer price. Therefore a greenshoe share option is one of the things that buyers look for in a company’s offer document. The name greenshoe comes from an American shoe-making company that first used this option in its IPO in 1919. The term used in the IPO document for the greenshoe share option is usually “over-allotment option.” The greenshoe share option was introduced to the Indian markets by SEBI only in 2003.