Many Initial Public Offerings or IPOs have been swamping the markets in the past one and a half years as bullish market sentiment continues to dominate the market narrative and both the Sensex and the Nifty are operating at their lifetime highs.

Before we try and understand what a greenshoe option is, it is necessary to be clear about the concept of an IPO. An IPO is a market mechanism through which a company sells its share to retail as well as institutional investors. Companies looking to launch their IPO in India come from a wide range and lineage. Some are new and charting a digital business course while others are old, established and conduct their business in traditional business domains.

Before applying for an IPO, investors are often urged to read the offer documents carefully before investing. A company seeking to enlist its shares on the bourses is mandatorily required to comply with the statutory regulations as prescribed by SEBI, the market regulator from time to time.

The offer document provides valuable information about the company such as its strengths, risk factors, subsidiary details, industry supervision etc. The offer document also makes a mention of a technical jargon called the “Greenshoe option”.

What is the Greenshoe option?

The greenshoe option in IPO is primarily employed to make sure that the shares of the company are listed at a good price and that they do not sink below the issue price. Any company which is looking to tap the IPO route takes the help of investment bankers known as underwriters. The underwriters take upon themselves the responsibility of finding buyers for the shares of the company and making the IPO a success. Of course, they do this work in return for a certain commission.

The greenshoe option in the Indian investment milieu is called the over-allotment option. It allows underwriters to intervene in the market within a period of 30-days to stabilise the share price. The underwriters are called upon to buy shares from the market in case the price of the listed shares topples below the issue price.

The greenshoe option permits underwriters to buy a 15% share of the stocks to be listed, in case the share price opens up above the issue price or in case it keeps falling below the listed price.

From a retail investor’s point of view, an IPO which has a greenshoe option bumps up the investor’s chances of bagging the shares. It also signals to the market that the stock price will likely stabilise in a month.

Why is it called the greenshoe option?

The term originates from the Green Shoe manufacturing company which was the first company in the history of financial markets to incorporate the greenshoe clause in their agreement with the underwriters. This market process is also called the over-allotment option because the company is required to set aside some shares for the underwriters in addition to shares offered to retail and institutional investors during an IPO.

Greenshoe option in India

Greenshoe option in India was first introduced in 2003 by the Securities and Exchange Board of India in order to stabilise the share prices of companies that had been listed on the Nifty and the Sensex. In 2009, several realty companies included the greenshoe option in their IPOs to counter the volatility wreaking havoc in the markets in the aftermath of the global recession.

Practical application of the greenshoe option

The greenshoe option is exercised by underwriters in two ways. Firstly, if the share price is a success and the shares are listed above the issue price, then the underwriters buy the shares from the company at the offer price and issue those shares to their clients at a profit. In case, the share price tanks and lists below the issue price, then the underwriters buy the shares from the market and not the company. This increases the demand for the shares in the market and supports the stock price.

Suppose that a company is planning on enlisting 1 lakh shares of its company. If the company is keen on including the greenshoe option in its IPO, it will have to issue 15% more shares. Consequently, it will have to issue 1,15,000 shares, out of which 15,000 shares will be allotted to the underwriters.

It must be noted here that the company does not specifically issue any new shares for over-allotment. The 15% shares are borrowed from the promoters. The underwriters sign another agreement with the promoters in respect of the shares borrowed.

Once the shares are listed on the bourses, the underwriters get to work. In case, the shares start falling, they start buying shares and pushing up the demand, which helps slow down the fall in prices.

The final word:

The market regulator has instituted the greenshoe mechanism to protect retail investors and companies alike whose prospects can be dented due to extreme volatility in the markets. Underwriters play a strategic role post the listing of the shares on the exchanges and help stabilise the share price.