IPOs: What is green-shoe option and how does it help investors?
One of the problems in IPO has been the post-issue price decline as compared to the issue price. This often has left retail investors feeling high and dry. A solution to this problem is seen in the addition of the green-shoe option in the issue, which is seen in the red herring prospectus. Let us try to understand the relevance and significance of a green-shoe option from the investors’ point of view.
What is a green-shoe option?
A green-shoe option or over-allotment provision in IPOs was introduced by Securities & Exchange Board of India (SEBI) in 2003 mainly to stabilise the after-market prices of shares. It is nothing but a clause contained in the underwriting agreement of an initial public offering (IPO), which permits underwriters to buy and offer for sale up to an extra 15 per cent of the shares at the offer price for a window up to 30 days after the listing of shares. This clause is made with the sole aim to stabilise the after-market prices of shares.
Example – Let’s assume that a company issues 100 million shares through an IPO. The underwriter of the IPO is allowed to sell an additional allocation of 15 per cent of the offering size - this would amount to 15 million extra shares. The underwriter does not have these shares to sell; so, it effectively shorts the shares (sells shares it does not have). The underwriter will need to buy and obtain the shares from somewhere in order to close its short position.
What happens if the share price falls?
If the share price falls in the immediate period following the IPO, the underwriter will buy the 15 million shares to support the share price and effectively closes out its short position. The underwriter will make a profit by selling the additional shares at the IPO price and buying them back at a lower price.
What happens if the share price rises?
This is a problem as the underwriter needs to close the short position. The underwriter, who sold the shares at the issue price, would have to buy them back at the higher price prevailing in the market to deliver these shares to the investor. However, the underwriter would clearly make a loss in this situation. This is where the green-shoe option kicks in! It allows the underwriter to buy the shares at an issue price from the issuer. The issuer receives additional proceeds and the underwriter would not gain or lose.
Hence, from an investor’s point of view, those companies, which have green-shoe options in their IPO process, are good because the listed shares of these companies will have a built-in price stabilising mechanism that will ensure that the prices will not go below its offer price, benefitting both issuers & investors.