The Green Shoe Option in Investment Banking

In many cases, IPOs are thought of as being underpriced. This means that as soon as the IPO is listed in the market, investor demand appears, and as a result, the price of the newly listed shares goes up. This is the situation that the issuing company, as well as the investment banker, wants to be in. This is because it creates customer satisfaction amongst the investment community, and they will be inclined towards buying into future issues by the issuing company as well as the investment banker.

However, in some cases, the prices of the newly issued shares start going down. This could be due to external factors such as the overall state of the economy. In such cases, investors often tend to be dissatisfied with the results. Hence, in order to prevent this, a strategy called the greenshoe option is exercised by the investment bankers. In this article, we will understand what the greenshoe option is and what is accomplished by utilizing this option.

What is a Greenshoe Option?

Greenshoe option gives special powers to the “stabilizing agent” appointed by the issuing company. In most cases, the lead investment banker is appointed as the “stabilizing agent.” As per these powers, the investment banker has the option of issuing up to 15% additional shares as compared to the initial issue. This means that if the initial issue was determined to be for 10000 shares, the investment bankers could create as many as 1500 additional shares. Hence, a total of 11500 shares are issued to the retail investors in the market. These shares are also allocated to the investors on a pro-rata basis.

However, from the point of view of the company, the money received from the sale of 10000 shares is put into the equity account. On the other hand, the money received from the sale of these additional 1500 shares is kept in a separate stabilizing account. This account is not controlled by the company but is instead controlled by the investment banker. The idea is that the money in this account is to be kept as a reserve. If the price of the shares starts falling below the issue price, this money will be used by the investment bankers to start buying shares in the open market. This will lead to an increase in demand, which would mean that the price of the shares would also go up.

Before the company goes public, it would have to inform the investors that a greenshoe option has been given to the investment bankers. Also, it would have to mention the stabilization period for which this option is to be exercised. The stabilization period cannot exceed 30 days. This means that at the end of 30 days, the investment bankers will no longer be authorized to trade on behalf of the issuing company in order to stabilize their prices.

How the Greenshoe Option is Settled?

The greenshoe option begins by borrowing up to 15% additional shares from the promoters. The lock-in period regulations are not applicable to the greenshoe option. Hence, promoters can lend their shares even though they are within the lock-in period. The process can end in one of the three ways depending upon the market conditions:

• If the investment banker purchases shares which are equal in number to the additional issue, the account is settled. For instance, during the IPO, 1500 shares were issued in the market. However, after the IPO, 1500 shares were purchased from the market and returned to the promoters. Hence, no additional shares were created. The balance money is also returned to the issuing company.

• In some cases, the price remains stable, and hence the investment banker does not have to perform any trading activity. This means that the entire amount in the stabilization account remains untouched. In such cases, it is assumed that the size of the equity issue has increased, and the entire amount is transferred from the stabilization account to the equity account.

• If the prices of the shares increases and the funds get exhausted before all the shares are purchased, then new shares are issued to the promoters. For instance, 1500 shares were first issued, whereas only 1350 could be purchased back due to an increase in prices. Now the investment banker will return the 1350 shares, whereas they will also ask the company to issue 150 more shares.

Benefits of Greenshoe Option

A greenshoe option is a powerful tool in the hand of the investment banker. As seen above, the banker can use the money to buy back the shares in case of a short position. However, if the prices go on increasing, there is no compulsion for them to buy any shares and return the promoters. Thus, the investment banker is equipped to protect the company from attacks by bearish investors. The final decision regarding the quantum of shares to be bought back, as well as the price at which they have to be bought back, are left to the investment banker.

The bottom line is that the greenshoe option is an exceptional strategy which is used by investment banks to help the newly issued shares to be stabilized in the short run.