A greenshoe, which is also referred to as an overallotment option, is a provision in an underwriting agreement that allows the investment banks underwriting a public offering to sell more shares than originally planned to help stabilize the stock price after the offering. The term “greenshoe” comes from Green Shoe Manufacturing Company (now Stride Rite), which was the first company to use this mechanism.
Greenshoes are typically 15% of the potential base offering. If demand for an offering is much greater, a company would increase the base deal size. The window to exercise the greenshoe is almost always 30 days. Most typically, greenshoes are additional shares issued by the company but the greenshoe can be comprised of shares held by a selling stockholder.
A greenshoe can exist in both an “initial public offering” (“IPO”) or a follow-on public offering. Greenshoes are not used in “registered direct offerings” (“RDOs”) or deals referred to as “underwritten RDOs”.
Here is a simple example of a greenshoe:
- The company plans to sell 10 million shares of its common stock, which are referred to as the base shares, in its IPO.
- The greenshoe would be 1,500,000 shares, or 15% of the base shares.
- If the underwriters elect to exercise the greenshoe, they may sell up to 11,500,000 shares to investors, which is the sum of the base shares plus the greenshoe.
Why a greenshoe exists?
The greenshoe helps:
- stabilize the stock price after a public offering;
- meet excess demand if investors want more shares; and
- protect underwriters from losses during the first trading days.
In practice, underwriters use the greenshoe to stabilize the stock price during the first 30 days after a public offering. The mechanics revolve around short-selling and covering that short position depending on where the price trades.
For example, using the example above of a 10 million share base offering, with a 1.5 million share greenshoe, and a public offering price of $10:
- The underwriters will sell 11.5 million shares to investors, even though only 10 million shares are initially issued by the company to the underwriters.
- They do this by borrowing 1.5 million shares from the issuer or selling syndicate and creating a short position of 1.5 million shares.
- As a result, immediately after the offering, investors hold 11.5 million shares, only 10 million of which are actually issued, and the underwriters are short 1.5 million shares.
This short position is the key tool for stabilization. If the stock price falls below the offering price, for example, the price falls to $8.00, the underwriters will buy shares in the open market at $8 and use those shares to cover their 1.5 million shares short position. That open market-buying demand supports the stock price, and the underwriters profit (sold at $10 and bought back at $8). In this case, the greenshoe would not be exercised, the total shares issued in the offering is 10 million, and the company will have raised $100 million in gross proceeds.
If the stock price rises above the offering price, for example, it trades to $15.00, buying shares in the open market would be expensive for the underwriters. Instead, underwriters exercise the greenshoe and buy 1.5 million shares from the company at $10.00. They then deliver those shares to cover their short position. In this case, the greenshoe is exercised, the total shares issued in the offering is 11.5 million, and the company will have raised $115 million in gross proceeds.
Occasionally, the stock price is volatile and, during the greenshoe period, may trade above and below the offering price, which could result in a partial exercise of the greenshoe to cover the shares to cover the portion of the short position that resulted while the stock price was higher than the offering price. Generally, the greenshoe cannot be exercised in an amount that exceeds the net short position at the time of exercise.
