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What is a Greenshoe Option IPO

14 Jul 2023

If you are interested in the stock market, you must be aware of the notion of IPOs. An IPO is a market event that permits a business to sell a part of its shares to institutional and retail investors to infuse new cash into the firm. IPOs are an excellent method for investors to acquire high-quality equities, and the market pays close attention to them. Before an IPO, a firm releases an offer document outlining the offering's terms and conditions. The offer document informs the knowledgeable investor on a variety of aspects such as the company's corporate subsidiary structure, risk factors, the company's aims and strengths, and so on.

Before participating in an upcoming IPO, an investor must be able to grasp the offer document. However, this is easier said than done since the paper is often couched in financial jargon and terminology that are difficult to grasp. Greenshoe shares or greenshoe options are two significant terms that investors should be aware of while reading such offer paperwork. What is a greenshoe option, and why is it important for the IPO? To comprehend this, you must first understand the IPO process and what an underwriter is. Discover the latest updates and insights on the upcoming IPOs 2023!

Greenshoe Shares and the Underwriter

When a firm intends to go public, it hires the services of an underwriter - which is a bank or group of banks. The underwriter's task is to find purchasers for the firm's shares at the price set by the company. After the underwriter has placed the company's stock on the market for sale, one of two things may occur:

  • The shares are purchased at a lower price than the offer price. This has bad consequences since it gives the impression that the company's shares aren't in high demand, which may lead to a drop in share price because new purchasers may wish to sell the recently purchased shares to reduce their losses.
  • The shares were purchased at or above the company's offer price. This has favourable results for the firm since it shows that there is interest in the company's stock.

The greenshoe option procedure gets triggered in the second situation. It is simply an intervention mechanism used by the underwriter to buy back a certain percentage of the company's shares to support dropping prices.

What is a Greenshoe Option?

Simply explained, a greenshoe is an option exercised by the underwriter to buy back a specified number of the company's shares at a predetermined price to support the share price without putting any of its own money at risk. The underwriter is allowed to do so because, at the time of the IPO, the firm provides an extra 15 percent share to the underwriter purely for risk management purposes if the share price falls below the offer price after listing.

The underwriter sells these shares short only to buy them back at the same price at which they were sold. If the scrip's price rises, the underwriter may purchase them back at the same price, exiting the position at no-profit, no-loss. The greenshoe option refers to the exceptional privilege that allows the underwriter to purchase back the shares at the offer price alone. If the price falls below the offer price, the underwriter buys the shares back at the market price. The underwriter's significant purchasing move leads the stock price to climb. The underwriter also receives a per-share profit equivalent to the drop in share price after listing. The following example clarifies the greenshoe choice process:

  • The corporation sells its shares to an underwriter for Rs 10 per share. At the offer prices, the underwriter sells 115 per cent of the shares. This effectively suggests that the underwriter is 15% short.
  • The price has dropped to Rs 8 after the listing. Instead of exercising the greenshoe shares option, the underwriter acquires the stock for Rs 8. This buying activity boosts the stock's price. The underwriter earns Rs 2 per share.
  • If the price rises to Rs 12, the underwriter exercises the greenshoe shares option, which allows him to buy back the shares at Rs 10 only if the market price is Rs 12.

Greenshoe Option Process Guidelines

  • The greenshoe share option may be exercised by the underwriter or the stabilising agent only within 30 days of the IPO date.
  • For the greenshoe option procedure, the issuing business may only lend 15% of the entire offer amount.
  • The underwriter may execute the greenshoe share option in whole or in part, i.e., depending on the underlying stock's price movement relative to the offer price, the underwriter may acquire back all or a portion of the shares as part of the greenshoe share option.

Greenshoe Share Options Importance

If the IPO paperwork specifies that the firm has a greenshoe option agreement with its underwriter, it gives investors confidence that the company's share is unlikely to fall far below the offer price. As a result, a greenshoe share option is one of the features that purchasers seek in an offer contract. The term "greenshoe" refers to an American shoe manufacturer that utilised this option in its initial public offering in 1919. The greenshoe share option is commonly referred to as an "over-allotment option" in the IPO prospectus. SEBI just introduced the greenshoe share option to Indian markets in 2003.

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Related articles: 5 Tips for Investing In IPOs | What's the big deal about IPOs | Clearing the confusion from IPOs | IPO in India- The future looks bright | Upcoming IPO

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