What it means
When a company floats, the underwriters agree to sell a set number of shares, but they are permitted to take orders for more. Selling that extra allocation leaves the banks technically short of stock, and the greenshoe is the tool that lets them square the position without risk.
If the shares trade above the offer price after listing, buying back in the market would be expensive. The banks instead exercise the option, taking the extra shares straight from the company at the original offer price, and the company collects additional proceeds.
If the shares trade below the offer price, the banks close their short position by buying in the market. That buying supports a sagging price in the first days of trading, and the difference between what they sold at and what they paid covers the cost of stabilising.
The size is conventionally capped at 15% of the base offering, a limit written into the rules that govern price stabilisation in most major markets. The option normally lasts about 30 days from listing, and the underwriters must disclose whether and when they exercised it.
The mechanism is not free money for anyone. It shifts a modest amount of price risk from the company to the underwriters in exchange for giving them a profitable position when the deal goes well, and it is used in secondary offerings and bond issues as well as flotations.
In practice
Real-world examples.
Example
A payments company lists 20,000,000 shares at $32.00 and includes a 3,000,000 share over-allotment. Demand is heavy, the stock closes its first day 18% up, and the banks exercise in full, handing the company an extra $96,000,000 before fees.
Example
A mining group prices a secondary offering at the low end of its range on a nervous morning. The stock drifts under the offer price for a fortnight, the stabilising bank buys steadily in the market, and the greenshoe lapses unexercised at the end of the stabilisation period.
Example
A retail investor reads a flotation prospectus and notices the share count quoted two ways: with and without full exercise of the over-allotment option. She works out her dilution using the larger figure, since that is the outcome if the deal goes well.
Formula
Calculation
Maximum over-allotment shares = base offering shares x 15%
Total shares sold = base offering + over-allotment exercised
A company floats 10,000,000 shares at $20.00 each, a base offering of $200,000,000. The greenshoe permits 10,000,000 x 15% = 1,500,000 extra shares, so the underwriters take orders for 11,500,000 shares and collect 11,500,000 x $20.00 = $230,000,000.
The stock opens well and trades at $23.00, so the banks exercise the option and buy the 1,500,000 extra shares from the company at $20.00. With a 7% underwriting discount, fees are $230,000,000 x 7% = $16,100,000 and the company nets $230,000,000 - $16,100,000 = $213,900,000. Had the stock instead fallen to $17.50, the banks would have bought 1,500,000 shares in the market for 1,500,000 x $17.50 = $26,250,000 against the $30,000,000 they had sold them for, a gross difference of $3,750,000.Case study
Seen in the real world.
This is an illustrative, fictional scenario. Larkfield Diagnostics, an invented laboratory equipment maker, planned a flotation of 8,000,000 shares at $25.00, raising $200,000,000 before fees. Its underwriters negotiated a standard over-allotment of 8,000,000 x 15% = 1,200,000 shares and took orders for 9,200,000.
Trading opened at $27.50 and never dipped below the offer price. On day nine the underwriters exercised the option in full, and the fictional company issued 1,200,000 additional shares at $25.00, adding 1,200,000 x $25.00 = $30,000,000 to gross proceeds for a total of $230,000,000.
The finance director's board note made two points. The extra cash brought forward a planned second manufacturing line by a year, but the share count had risen from 8,000,000 to 9,200,000 of newly issued stock, so every existing holder had been diluted by 15% more than the headline prospectus figure implied.
Watch out
Common mistakes.
- Believing the greenshoe means the company can issue unlimited extra shares, when the customary ceiling is 15% of the base offering and it is disclosed in advance.
- Reading price support during the first weeks of trading as genuine market demand, when some of it is the underwriters closing an over-allotment short.
- Calculating ownership percentages from the base offering alone and being surprised when the final share count comes in higher.
Questions
People also ask.
Why is it called a greenshoe?
The first company to include one in its offering was a footwear manufacturer whose name contained the word, and the nickname stuck long after the formal term over-allotment option was adopted.
Who benefits most from the option?
The underwriters gain a hedged position and the company gains extra proceeds when the deal is well received, while existing holders take slightly more dilution.
How long does the option last?
Typically about 30 days from the start of trading, after which any unexercised portion simply lapses.
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