Introduction to Green Shoe Option
When an IPO is launched, the number of shares and the price per share are specified in the IPO documents and also the underwriting party is so informed, however, in the underwriting contract there might be a clause which allows the underwriters to increase the number of shares to a number higher than that specified in the contract to meet the greater than expected demand of the security.
Explanation of Green Shoe Option
This type of option is at times also known as the over-allotment option, however, it is termed as ‘greenshoe’ option after a company named Green Shoe Manufacturing Company who was the forerunner in this form of option and had issued it for the first time. If such an option is not available and the IPO is oversubscribed, that is, more applications are received than the number of available shares in the IPO, the price per issue rises due to the demand and supply forces of the market. Therefore, having this option prevents such an unprecedented rise in price if the company doesn’t want it.
Features of Green Shoe Option
Following are the features are given below:
- Maximum Increase: There can be a maximum increase of 15% of the original number of shares so that the option is not mis-utilized and there are limits on its usage, to prevent the integrity of capital markets.
- Regulated by SEC: SEC has permitted this type of option and constantly regulate the same, therefore issuing it is within the boundaries of keeping the integrity of capital market intact.
- Covered Short Position: According to the SEC, the Green shoe option leads to a covered short position because it gives the underwriters the option to purchase the additional stock from the issuer of the stock.
- Time Frame: According to the SEC, the time during which the underwriter or the syndicate can exercise the green shoe option is mentioned in the underwriting agreement, but most of the times this time frame is 30 days. Most of the times, when the price at which the application is made is significantly higher than the price of the IPO, the green shoe is exercised concurrently, to avoid the hassle of doing a separate allotment of additional shares. But there are also the cases in which the option is not exercised before 30 days have passed.
Examples of Green Shoe Option
Recently, Saudi Aramco went for an IPO, the performance on the exchange was so good that the share price went up by 10% of the offer price. To make the best of this situation, Goldman Sachs, its stabilizing manager exercised the green shoe option and issued 450 million additional shares and maximized the allowed limit of 15% in the 30 day period of the trading. This was a part of their book building process.
As per the article on Financial times published on October 3, 2019, the AB InBev’s Asia Unit issued additional shares worth $750 million to an issue of $5 billion as part of the IPO it released in Hong Kong. This was done by the bankers who completely used the allowable limit of over allotment or the green shoe option and sold additional 217.8 million shares which were 15% of the IPO
As per the article on Financial times published on October 25, 2019, the ESR Cayman, a logistics company with key focus in Asian markets issued made it public to initiate the IPO process to raise $1.2 billion and this included the green shoe option of 15% over allotment so that the total number of shares after including the same will become $1.8 billion. This was Hong Kong’s second biggest IPO for the year 2019 next only to the AB InBev’s IPO mentioned earlier.
Importance of Green Shoe Option
When an issue is oversubscribed, that is the number of applications received to purchase the shares is greater than the number of shares stated to be issued, the price of the shares may increase tremendously. This may not be a good thing for the issuer because a very high price will not make the shares trade very freely in the secondary market. Therefore, the issuer prefers a stable price and by way of the green shoe option, the issuer or the underwriter appointed by the issuer, is able to achieve the same and therefore keeps the price of the security within a desired range. This doesn’t hamper the amount of capital that the company is able to raise by reducing the premium because the number of shares increases.
Also there may be a case that the number of applications are lower, in that case the price may fall below the offered price, a situation that is known as a ‘break issue’. This may convey a wrong signal in the investing community because the investors can perceive the stock to be less attractive or riskier than it actually is. In such a case the underwriter or the issuer can buy back the shares at the offered price and reduce the number of shares offered, to stabilize the price.
Therefore, the most important role of these options is to maintain price stability of the issue and control the supply of the share that can give the underwriters a certain degree of flexibility.
Therefore, we can conclude by saying that the green shoe option is used for over allotment of the number of share in excess of the stated number in the IPO or any other share issue process. It is mostly stated in the underwriting contract and therefore gives the underwriters or the syndicate so formed the freedom of issuing greater number of shares if the demand for the same is high enough.
It is a mechanism to maintain the price stability in the market and is only one of its kind tool which is allowed by the SEC and is completely regulated by the same. Conventionally the maximum allowed over allotment is 15% of the stated number of shares but it can be different too and the allowed time is 30 days but companies may state a different time as per their need as long as the SEC or the regulator in the market allows.
This is a guide to Green Shoe Option. Here we also discuss the introduction to green shoe option and features along with examples and importance. You may also have a look at the following articles to learn more –