What is an Overallotment / Greenshoe Option?
An overallotment option, sometimes called a greenshoe option, is an option that is available to underwriters to sell additional shares during an Initial Public Offering (IPO). The underwriters are allowed to sell 15% more shares than the number of shares they originally agreed to sell, but 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 the underwriters. The underwriters, usually investment banks or brokerage agencies, can exercise the overallotment option if the demand for the shares exceeds the expected demand and the sale price is significantly higher than the offer price.
Reasons for Overallotment / Greenshoe
The following are some of the reasons why an underwriter may exercise an overallotment option for 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 for the shares of a company. This occurs mostly when a well-known company issues an IPO because many more investors are likely to 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.
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 do an IPO of two million shares, the underwriters can exercise the 15% overallotment option to sell a total of 2.3 million shares. When the shares become publicly traded, the underwriters can then buy back the extra 0.3 million shares. This helps to stabilize fluctuating, volatile share prices by controlling the supply of the shares according to their demand.
Price exceeds the offer price
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 additional shares at the original offer price without incurring a loss. The difference between the offer price and the current market price helps to compensate for any loss incurred when the shares were trading below the offer price.
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 Facebook stock started trading, the initial price was $42.05, an increase of 11% above the IPO price. The stock soon became volatile, and the stock price fell to $38. In total, the underwriters sold 484 million Facebook shares at $38. This 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
Underwriters may choose to employ either a partial or full greenshoe. In a partial greenshoe, the underwriter only buys back a part of the shares from the market before the price increases. A full greenshoe is just what it sounds like: the underwriter exercises its whole option to obtain 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 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 their shares is either increasing or decreasing.
SEC Regulations on Overallotment
The Securities and Exchange Commission (SEC) allows underwriters to engage in naked short sales in a share offering. Usually, underwriters use short selling when they anticipate a price fall, but the practice exposes them to price increases as a risk. In the United States, underwriters engage in short selling the offering and purchasing it in the aftermarket to stabilize prices. While selling short exerts downward pressure on the stock’s price, this tactic may facilitate a more stable offering that ultimately leads to a more successful stock offering.
However, in 2008, the SEC eliminated the practice of what it termed “abusive naked short selling” during IPO operations Some underwriters engaged in naked short selling as a way of influencing stock prices. The practice created a strong perception that the shares of a particular company were moving very actively, whereas, in fact, only a small number of market players were manipulating the price changes.
CFI is a global provider of the Financial Modeling & Valuation Analyst (FMVA)™ certification program and several other courses for finance professionals. To help you advance your career, check out the additional CFI resources below: