A Greenshoe Option Allows Underwriters to Sell Additional Shares

In many large initial public offerings (IPOs), the bank underwriters decide to exercise their “greenshoe option” to sell additional company shares. This special share arrangement is formally known as the “over-allotment option”. Companies such as Facebook, Alibaba, Exxon Mobil and Saudi Aramco have utilized this option following their respective debuts on public markets.

A greenshoe option is a clause in an underwriting agreement that allows the underwriters to issue additional shares following the IPO. Higher investor demand than anticipated underlies exercising this option. The underwriters purchase the shares at the same price as the base shares in the IPO. Then, they sell the shares to investors. Typically, the greenshoe clause allows the underwriters to sell 15% more shares that the original issue amount. Normally, additional sales must take place within a maximum of 30 days following the IPO.

Variations of the Greenshoe Option

The name of the practice originates from the Green Shoe Manufacturing Company, now part of Wolverine World Wide, Inc. There are a couple different variations of the greenshoe option—full, partial, or reverse. In a partial greenshoe, the underwriters are only able to exercise part of their option to obtain additional shares at the IPO price. In other words, they are only able to buy back some of the shares at the IPO base price before the price increases. When the underwriters are unable to buy back any of the shares before the price rises above the IPO base price, a full greenshoe has occurred.

Finally, if the share price falls below the offering price after the IPO, the underwriters are may exercise a reverse greenshoe. In a reverse greenshoe, the underwriters may buy shares in the open market and then sell them back to the company at a higher price.

Greenshoe Option Underwriting
Image credit: Carlos Muza

Why Use a Greenshoe Option?

Although the primary reason companies decide to exercise their over-allotment option following an IPO is to raise additional capital in response to high investor demand, sometimes there are other reasons. In some situations, companies will utilize the over-allotment option for price stabilization purposes. If the stock price falls below the IPO price, underwriters will lose money. In response, the underwriters may exercise the over-allotment option. Then they can buy back the newly issued additional shares at a lower price. This has the effect of reducing price volatility. Finally, the use of the greenshoe option in IPOs is beneficial to underwriters, boosting their principal trading payoffs.

Facebook, Alibaba and Saudi Aramco Examples

Facebook’s IPO in 2012 provides an interesting illustration of the greenshoe option. On the first day Facebook shares became publicly traded, its stock initially traded at $42.05, or 11% above the IPO price. As the day progressed, however, the stock price fell to $38 per share and became more volatile. As the lead underwriter, Morgan Stanley stepped in to stabilize the situation. Together with the group of other investment banks that served as underwriters for the deal, they exercised the over-allotment option to sell 63 million additional Facebook shares. That move gave the underwriters an opportunity to buy back the additional 63 million shares to stabilize prices. Due to strong investor demand, a number of other investors bought up the newly issued shares alongside the underwriters.

In 2014, Alibaba set a record as the biggest IPO in history. This occurred after underwriters exercised their greenshoe option to release additional shares. The underwriters issued an additional 48 million shares on Alibaba’s first day of trading on the New York Stock Exchange (NYSE). Alibaba exercised its overallotment option due to higher than expected investor demand. This made Alibaba’s IPO worth about $25 billion, surpassing the previous $24.3 billion IPO record set by Agricultural Bank of China in 2010.

In its record-breaking $29.4 billion IPO in December 2019, Saudi Aramco exercised its over-allotment option. Aramco initially raised $25.6 billion in its IPO. The underwriters observed an immediate surge in investor demand after going public. Thus, they decided to exert their greenshoe option to issue an additional 450 million shares. The shares, which trade on Saudi Arabia’s stock exchange known as the Tadawul, rose 10% on their first day of trading. The price gave Aramco a valuation of $1.88 trillion, slightly shy of Crown Prince Mohammed bin Salman’s $2 trillion valuation goal.

SEC Supervises with Regulation M

The Securities and Exchange Commission (SEC) permits underwriters to utilize their over-allotment option to sell more shares to investors than they have committed to buy from the company. Regulation M under the Securities Exchange Act of 1934 governs underwriters that use their over-allotment option following an IPO. The SEC designed Regulation M to prevent market manipulation by underwriters and other participants in securities offerings. Regulation M consists of six rules that govern the distribution of securities and short selling restrictions.

As IPO activity continues to soar in 2021, the greenshoe option has continued to be a popular tool for underwriters. They may use it to promote price stabilization and address heightened investor demand. The greenshoe option has played a role in some of the largest IPOs in recent years and likely will continue to be highly utilized in the capital markets.