Green Shoe Option in stock market
What is a Green Shoe Option?
The Green Shoe Option allows underwriters to purchase up to an additional 15% of the company’s shares at the IPO price. It is a clause contained in an underwriting agreement. This option is typically chosen when they have to stabilize the stock price during the initial trading days after the IPO.
Stride Rite Corporation, which was the first company to grant this option in its IPO. It is known as Green Shoe Manufacturing Company. That’s why it is called Green Shoe Option
How Does the Green Shoe Option Work?
Step-by-step breakdown of how the Green Shoe Option works:
- IPO Allocation: Underwriters manage this process of IPO. When a company goes public, it issues a fixed number of shares at a fixed price band.
- Over-Allotment: Underwriters may allocate or sell up to 15% more shares than the initially offered amount of share. This over-allotment method is covered by the Green Shoe Option.
- Price Stabilization: If the stock price drops below the IPO price in coming trading days after IPO, underwriters have a option to buy back shares from the open market to stabilize the price. Conversely, if the stock price rises, they can choose the Green Shoe Option to buy shares directly from the company at the IPO price, so that they can cover their short position.
- Final Outcome: This buying and selling of 15% additional share ensures market stability and prevents extreme volatility during the initial trading period after the IPO.
Advantages and Disadvantages of the Green Shoe Option
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Advantages |
Disadvantages |
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It Provides price stability after the IPO in initial trading period. |
It dilutes the ownership of existing shareholders. |
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It boosts investor confidence in the IPO. |
Critics see it as a market manipulation tool |
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It Allows underwriters to manage supply and demand. |
It restricts flexibility. Limiting it to a maximum of 15% of the total issue, |
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It Encourages retail investor to apply for IPO due to reduced volatility. |
if market sentiment is negative. It can not completely prevent price drops |
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It Creates an opportunity for companies to raise additional capital if needed. |
It is a complex option to implement, it requires detailed regulatory compliance. |
Real-World Example of a Green Shoe Option
A most famous example of the Green Shoe Option in action was during Facebook’s IPO in 2012. Facebook issued 421 million shares, and underwriters had to exercise the Green Shoe Option to stabilize the share price by purchasing an additional 63 million shares to stop price volatility.
Frequently Asked Questions (FAQ)
No, the Green Shoe Option is not mandatory. It is a common practice in major IPOs to ensure price stability. It depends on the company and underwriters’ agreement whether they have opted it or not.
The Green Shoe Option benefits multiple stakeholders:
- Investors: It reduces price volatility.
- Issuing Company: it helps to build confidence from investors.
- Underwriters: It helps them to manage market risks effectively.
It helps underwriters to stabilize the stock price, it also reduces the likelihood of extreme price going down, by doing so it protects retail and institutional investors from sudden losses.
Yes, It dilutes the share of the company promoters. Green Shoe Option increases the total number of shares in the market,
Yes, There are other methods too, but they are much complicated so underwriters prefers this option.
Yes, They are regulated by SEBI in India.
Yes, It is legal in India,
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Conclusion
The Green Shoe Option is a vital component of IPO processes, it acts as a safety net against price volatility by balancing the interests of companies, underwriters, and investors, it also fosters confidence in public offerings. While it has certain disadvantages, it has more benefits that often outweigh the drawbacks, which makes it as a standard practice in the Stock market during IPO.
