23 October 2009
A provision contained in an underwriting agreement that gives the underwriter the right to sell investors more shares than originally planned by the issuer. This would normally be done if the demand for a security issue proves higher than expected. Legally referred to as an over-allotment option.
A greenshoe option can provide additional price stability to a security issue because the underwriter has the ability to increase supply and smooth out price fluctuations if demand surges.
The Origin of the Greenshoe The term "greenshoe" came from the Green Shoe Manufacturing Company (now called Stride Rite Corporation), founded in 1919. It was the first company to implement the greenshoe clause into their underwriting agreement.
In a company prospectus, the legal term for the greenshoe is "over-allotment option", because in addition to the shares originally offered, shares are set aside for underwriters. This type of option is the only means permitted by the Securities and Exchange Commission (SEC) for an underwriter to legally stabilize the price of a new issue after the offering price has been determined. The SEC introduced this option in order to enhance the efficiency and competitiveness of the fundraising process for IPOs. (Read more about how the SEC protects investors in Policing The Securities Market: An Overview Of The SEC.)
Price Stabilization This is how a greenshoe option works:
The underwriter works as a liaison (like a dealer), finding buyers for the shares that their client is offering. A price for the shares is determined by the sellers (company owners and directors) and the buyers (underwriters and clients). When the price is determined, the shares are ready to publicly trade. The underwriter has to ensure that these shares do not trade below the offering price. If the underwriter finds there is a possibility of the shares trading below the offering price, they can exercise the greenshoe option. In order to keep the price under control, the underwriter oversells or shorts up to 15% more shares than initially offered by the company. (For more on the role of an underwriter in securities valuation, read Brokerage Functions: Underwriting And Agency Roles.)
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