Greenshoe / Overallotment

An option for underwriters to sell additional shares more than an IPO's original shares volume

What is an Overallotment / Greenshoe Option?

An over-allotment option, also known as a greenshoe option, is an option that is available to underwriters to sell additional shares that a company plans to sell during an Initial Public Offering (IPO). The underwriters are allowed to sell 15% more shares than the number of shares they originally planned to sell, and the option must be exercised within 30 days of the offering. The specific details of the allotment are contained in the IPO underwriting agreement between the issuing company and underwriters. The underwriters, usually investment banks and brokerage agencies, can exercise overallotment if the demand for the shares exceeds the expected demand and the price is more than the offer price.

 

Overallotment Option / Greenshoe diagram

 

Reasons for Overallotment / Greenshoe

The following are some of the reasons why an underwriter may exercise an overallotment of a company’s shares:

 

Demand for the company’s shares

The underwriters of a company’s shares may exercise the greenshoe option to benefit from the demand of the shares of a company. This occurs mostly when a well-known company issues an IPO because many investors will be interested in investing in well-known companies as opposed to lesser known companies. For example, when Facebook held its IPO in 2012, its shares were in high demand due to the company’s popularity and future potential. Oversubscription of the company’s shares allowed it to raise additional capital through overallotment to meet the demand.

 

Price stabilization

Overallotment can also be used as a price-stabilization strategy when there is an increasing or decreasing demand for a company’s shares. When the share prices go below the offer price, the underwriters suffer a loss, and they can buy the shares at a lower price to stabilize the price. Buying back the shares reduces the supply of the shares, resulting in an increase in the share prices. For example, if a company decides to go public by issuing 1 million shares, the underwriters can exercise overallotment and sell 1.15 million shares. When the shares become publicly traded, the underwriters can then buy back the extra 0.15 million shares. It helps to stabilize fluctuating share prices by controlling the supply of the shares according to their demand.

 

Price exceeds the offer price

The increasing demand for a company’s shares can raise the share prices to a price above the offer price. In such a scenario, the underwriters cannot buy back the shares at the current market price since doing so would result in a loss. At this point, the underwriters can exercise their greenshoe option to buy back additional shares at the original offer price without incurring a loss. The difference between the offer price and current market price helps to compensate for the loss incurred when the shares were trading below the offer price. The underwriters must exercise the overallotment option within 30 days of the date of issue for it to be valid.

 

Example – Overallotment of Facebook’s IPO

When Facebook held its IPO in 2012, it sold 421 million Facebook shares at $38 to the underwriters, which included a group of investment banks who were tasked with ensuring that the stocks get sold, and the capital raised sent to the company. In return, they would get 1.1% of the transaction. Morgan Stanley was the lead underwriter.

When the Facebook stocks started trading, the initial price was $42.05, an increase of 11% above the IPO price. The stocks soon became volatile, and the stock price fell to $38. In total, the underwriters sold 484 million Facebook shares at $38. It means that the underwriters exercised an allotment option by selling an additional 63 million shares. Press statements indicated that the underwriters stepped in and purchased additional shares as a way of stabilizing the prices. The underwriters had the opportunity of buying back the additional 63 million shares at $38 per share to compensate for any loss incurred in stabilizing the prices.

 

Full, Partial and Reverse Greenshoe

The number of shares that the underwriter buys from the market determines if they exercised a partial or full greenshoe. A partial greenshoe is when the underwriter only buys back a part of the shares from the market before the price increases, whereas a full greenshoe is when the underwriter is unable to buy back any shares from the market before the price increases. At this stage, the underwriter can exercise the option and buy back the additional shares at the initial offering price.

The reverse greenshoe option gives the underwriter the right to sell the shares to the issuer at a later date. It is used to support the price when its demand falls after the IPO, resulting in declining prices. The underwriter exercises the option by buying back the shares in the market and selling them to its issuer at a higher price. Companies use this technique to stabilize their stock prices when the demand for its shares is either increasing or decreasing.

 

SEC Regulations on Overallotment

The Securities Exchange Commission (SEC) allows underwriters to engage in naked short sales in a share offering. Underwriters create a naked short sell position by selling short more shares than the amount stated in the IPO. Usually, underwriters use short selling when they anticipate a price fall, but the practice exposes them to price increases because they create temporary demand for shares. In the United States, underwriters engage in short selling the offering and purchasing it in the aftermarket to stabilize prices.

However, in 2008, the SEC banned what it called “abusive naked short selling” as a method of driving down prices. Some underwriters engaged in naked short selling as a way of influencing stock prices. The practice created the perception that the shares of a particular company were gaining or losing whereas only a small number of market players were manipulating these changes.

 

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