Definition: The Greenshoe Option is a special provision in the underwriting agreement that allows the underwriter to sell more shares to the investors, than what has been planned by the issuer in the initial public offerings (IPOs).
In other words, Greenshoe option allows the underwriters or the syndicates (investment banks or brokerage agencies) to buy up to an additional 15% of company’s shares at the offering price. The Greenshoe option is legally termed as “over-allotment” in the IPO prospectus.
The underwriters exercise the Greenshoe option to stabilize the offering price of the share, in case the shares trade below or above the offering price. The underwriter works as a liaison with the company, who find the potential investors on the company’s behalf. The company and the syndicates decide the offering price jointly. Once the offering price is decided upon, the underwriter makes sure that shares do not trade below this price.
Once the shares are traded in the public, the task of an underwriter begins. If the shares trade below the offering price, called as “broke issue” or “broke syndicate bid,” the underwriter sells its 15% additional shares to the public, thereby increasing the offering size. Once the additional shares along with initial offerings are priced and becomes effective, the underwriter buys back its additional 15% shares at or below the offering price, thereby stabilizing and controlling the initial price bid.
In case, the shares trade above the offering price; the underwriters could not buy back its shares because they have to pay a higher price for the shares which were sold at the offering price in the market. Here, Greenshoe option is very helpful for the underwriters as it allows them to buy back their shares at the offering price, thereby protecting them from the losses.
Thus, Greenshoe option allows the underwriter to stabilize the share prices by increasing or decreasing the supply of shares according to public demand.
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