Greenshoe Option

What Is a Greenshoe Option?

A greenshoe option is a provision in an initial public offering (IPO) underwriting agreement that grants the underwriter the right to sell more shares than originally planned if the demand for a security issue proves higher than expected. It is also called an over-allotment option.

How a Greenshoe Option Works

A greenshoe option provides additional price stability to a security issue because the underwriter can increase supply and smooth out price fluctuations. It is the only type of price stabilization measure permitted by the Securities and Exchange Commission (SEC).

Greenshoe options typically allow underwriters to sell up to 15% more shares than the original amount set by the issuer for up to 30 days after the IPO if demand conditions warrant such action. For example, if a company instructs the underwriters to sell 200 million shares, the underwriters can issue an additional 30 million shares by exercising a greenshoe option (200 million shares x 15%).

Since underwriters receive their commission as a percentage of the IPO, they have the incentive to make it as large as possible. The prospectus, which the issuing company files with the SEC before the IPO, details the actual percentage and conditions related to the option.

Underwriters use greenshoe options in one of two ways. First, if the IPO is a success and the share price surges, the underwriters exercise the option, buy the extra stock from the company at the predetermined price, and issue those shares, at a profit, to their clients. Conversely, if the price starts to fall, they buy back the shares from the market instead of the company to cover their short position, supporting the stock to stabilize its price.

Some issuers prefer not to include greenshoe options in their underwriting agreements under certain circumstances, such as if the issuer wants to fund a specific project with a fixed amount and has no requirement for additional capital.

Example of a Greenshoe Option

Facebook Inc., now Meta (META), agreed to a greenshoe option when it listed its shares in 2012. The underwriting syndicate, headed by Morgan Stanley (MS), agreed with Facebook to purchase 421 million shares at $38 per share, less a 1.1% underwriting fee. However, the syndicate sold at least 484 million shares to clients—15% above the initial allocation, effectively creating a short position of 63 million shares.

If Facebook shares had traded above the $38 IPO price shortly after listing, the underwriting syndicate would’ve exercised the greenshoe option to buy the 63 million shares from Facebook at $38 to cover their short position and avoid having to repurchase the shares at a higher price in the market.

However, because Facebook’s shares declined below the IPO price soon after it commenced trading, the underwriting syndicate covered its short position without exercising the greenshoe option at or around $38 to stabilize the price and defend it from steeper falls.

The Bottom Line

Greenshoe options give underwriters the opportunity to sell more shares during an IPO. They help to meet high demand and increase the amount of capital a company raises and are very common in the U.S. Typically, the over-allotment provision permits underwriters to sell up to 15% more shares at the agreed upon IPO price and can be exercised within 30 days after the IPO.