A “greenshoe option” allows an underwriter to buy extra shares from a company that goes public. It is an overallotment clause in the underwriting agreement of an initial public offering (IPO). It’s used to support the share price of a company following the IPO process.

A greenshoe option often allows underwriters to buy up to 15% more of a company’s shares than initially offered. Overallotting shares helps stabilize the price when public demand is higher or lower than expected.

How Does the Greenshoe Option Work?

A greenshoe option helps to reduce volatility in the market caused by supply-and-demand inconsistencies. An underwriter can short sell up to 15% more shares than a company planned to sell. This can be done for up to 30 days. For example, if a company offers 5 million shares, an underwriter can sell 5.75 million shares.

When the IPO goes public, the underwriter can buy back some of the shares listed on the market. By increasing or decreasing the supply of shares, the underwriter can help stabilize the share price.

There are two ways that an underwriter can exercise this option…

In a greenshoe option, the underwriter borrows shares from a company at a set price. And that’s usually the original issue price. If the share price rises, the underwriter can sell shares to investors for a profit.

If the market price falls below the offer price, the underwriter can buy back the shares from the market instead of the company. This gives the underwriter buying power to cover the short position. Overall, this helps to stabilize the share price and protect against loss.

Variations of the Greenshoe Option

The number of shares an underwriter buys back determines whether it exercises a full greenshoe or a partial greenshoe.

Full Option

A full greenshoe option occurs when an underwriter is unable to buy back any of the shares before the market price rises. The underwriter will then exercise its full option and buy back shares at the initial offering price.

Partial Option

In a partial greenshoe, the underwriter is able to buy back only some of the shares before the price rises. The underwriter exercises its partial option to buy back shares without suffering loss.

Reverse Option

A reverse greenshoe option allows underwriters to sell shares to the company at a set price in the future. If the stock price falls, this clause would let an underwriter buy shares at the market price and sell them to the issuer at a higher cost.

Greenshoe and reverse greenshoe options are similar to put and call options. A reverse greenshoe option is a put option that allows an underwriter to sell shares to the company at a higher price. In contrast, a regular greenshoe option allows the underwriter to buy shares from the company at a lower price.

To learn more about the IPO Process, check out our step-by-step guide to going public. Also, feel free to sign up for our free Investment U e-letter below. It’s packed with investing tips and tricks from experts.