Greenshoe
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A Green Shoe, also known by its legal title as an "over-allotment option" (the only way it can be referred to in a prospectus), gives underwriters the right to sell additional shares in a registered securities offering if demand for the securities is in excess of the original amount offered. The Green Shoe can vary in size up to 15% of the original number of shares offered.
The Green Shoe option is popular because it is the only SEC-permitted means for an underwriter to stabilize the price of a new issue post-pricing. Issuers will sometimes not permit a greenshoe on a transaction when they have a very specific objective for the offering, and do not want the possibility of raising more money than planned. The term "Green Shoe" comes from a company founded in 1919 as Green Shoe Manufacturing Company, now called Stride Rite Corporation, which was the first company to permit this practice to be used in an offering.
[edit] How it works
The mechanism by which the Green Shoe option works to provide stability and liquidity to a public offering is described in the following example:
A company intends to sell 1 million shares of their stock in a public offering through an investment banking firm (or group of firms which are known as the syndicate) whom the company has chosen to be the offering's underwriter(s). When the stock offering constitutes the first time that the stock will be available for trading in a public market, it is called an IPO (initial public offering). When there is already an established market for the shares and the company or its owners are simply selling more of their non-publicly traded stock, it is called a follow-on offering.
The underwriters function as the broker of these shares and find willing buyers among their clients. A price for the shares is determined by agreement between the sellers (the company's owners and directors) and the buyers (the underwriters and their clients). A part of the responsibility of the lead underwriter in running a successful offering is to help ensure that once the shares begin to publicly trade, they do not trade below the offering price.
When a public offering trades below its offering price, the offering is said to have "broke issue" or "broke syndicate bid". This creates the perception of an unstable or undesirable offering, which can lead to further selling and hesitant buying of the shares. To manage this possible situation, the underwriter initially oversells ("shorts") to their clients the offering by an additional 15% of the offering size. In this example then, the underwriter would sell 1.15 million shares of stock to their clients. Now when the offering is priced and those 1.15 million shares are "effective" (become eligible for public trading), the underwriter is able to support and stabilize the offering price bid (which is also known as the "syndicate bid") by buying back the extra 15% of shares (150,000 shares in this example) in the market at or below the offer price). They are able to do this without having to assume the market risk of being long this extra 15% of shares in their own account, as they are simply "covering" (closing out) their 15% oversell short.
So far this example has described a portion of the dynamics of a public offering where there is a need to stabilize the offering by supporting the bid at the offering price to ensure that it does not trade below or "break the offer". The circumstance of utilizing the "Green Shoe" is as follows:
If the offering is successful and is in strong demand such that the price of the stock immediately goes up and stays above the offering price, then the underwriter is left in the circumstance of having oversold the offering by 15% and is now technically short those shares. If they were to go into the open market to buy back that 15% of shares, the company would be buying back those shares at a higher price than it sold them at, and would incur a loss on the transaction.
This is where the over-allotment (Green Shoe) option comes into play: the company grants the underwriters the option to take from the company up to 15% of additional shares than the original offering size at the offering price. Now, if the underwriters were able to buy back all of its oversold shares at the offering price in support of the deal, they would not need to exercise any of the Green Shoe. But if they were only able to buy back some of the shares before the stock went higher, then they would exercise a partial Green Shoe for the rest of the shares. And, if they were not able to buy back any of the oversold 15% of shares at the offering price ("syndicate bid") because the stock immediately went and stayed up, then they would be able to completely cover their 15% short position by exercising the full Green Shoe.
[edit] See also
- Reverse Greenshoe, the converse of the greenshoe option
