The greenshoe option (or over-allotment option) is a useful tool for the stabilization of share prices after an initial public offering (IPO). In which a bank (underwriter) has a fundamental role in the immediate aftermath of the bid to stabilize share prices.
The bank is responsible for stabilizing the stock price by taking a short position in the market, ie short selling a certain number of shares of the company (over-allotment) at a price very close to the offer price.
To cover this position, the bank gets the option to purchase a certain amount of shares (usually 15% of the total number of shares offered). By a certain date (usually the green shoe option expires thirty days after the listing of securities on the market), at a price equal to issue price.
If the stock price falls in the first days of listing, the investment bank does not exercise the option and buys on the market the necessary actions to close the short position taken (increase demand for shares).
By doing so, to some extent the bank stops or slows down the share price decline. If the price of the stock rises in the days immediately following the implementation of the bid, the bank holding the green shoe option also takes action to increase the the free float to stop or slow the rise of stock price.
If a new issue is oversubscribed, such that the demand for the shares may be greater than the supply (under-pricing), the parties to the IPO, (banks) issue additional securities at the same conditions.
The redemption of the over-allotment option would involve the issuance of additional securities so that the supply would increase and thus the price would continue to fall – this is obviously a contingent.
In most cases there are shares that are placed in a public offering of new shares mainly arising in the course of a capital increase immediately before the initial public offering. The allotment, however, consists mainly of pure old shares, which are made available by an existing shareholder.
In some cases, the allotment of new shares is initiated under an additional capital increase in case of exercise of the greenshoe (or a combination of the two types of shares). The latter case, however, mean that stabilization measures are limited.
A further application synonymous with the use of the green shoes is to hedge against falling prices. The allotment in this case involves securities lending of a third shareholder, who undertakes to sell the shares in case of successful share issues (similar to inverted open offers). The issuing company then places the issue and the entire allotment, in the hope that this will be well received by the market.
Should this not be the case, and the price falls heavily, the stabilization is carried out within the statutory period of thirty days by buying back the shares. In this case, they then simply return the borrowed shares, and a profit could still be made on the positive difference between the offer price, and the repurchase price.
Pros and cons of the green shoes
The flexibility to respond quickly to rising or falling demand for the shares is a huge positive of the green shoes. For the issuer and the accompanying banks there is the possibility to place a maximum number of shares that may be extended at the same time acting as a risk buffer. Thus, in the case of low demand the exercise of the green shoes is simply waived and can still be a successful placement.
If the green shoe is connected with the issuance of new shares, there is an appropriate exercise of its dilutive effect on other shareholders, which is often seen negatively.