If you are about to open a trading account and want to invest in initial public offerings (IPOs), you must know about the “greenshoe option.” When a company raises money through an IPO, it should ensure that its stock price does not witness excess volatility on getting listed.
Too much volatility shows that the stock market is confused about the true value of the company’s shares. Besides, excess volatility can also affect investors’ confidence in the company that has come out with an IPO.
Often, during an IPO, companies are concerned about their stock price skyrocketing due to excessive demand right upon listing. Hence, to ensure that their stock price does not increase dramatically, companies can use a greenshoe option.
What is a greenshoe option?
A greenshoe option is used by companies raising money through an IPO to ensure stability in their stock price in case of excessive demand for their shares after the IPO. A greenshoe option provides an IPO’s underwriters a right to issue additional shares, which can be up to 15% of the original number of shares meant to be issued through an IPO.
But, you may wonder as to why an underwriter issues additional shares. Often, IPOs cause a lot of excitement among investors, resulting in heightened demand for shares. As the demand is high, it can result in a sharp rise in a company’s share price on listing.
To ensure that a company’s stock price is not extremely high upon listing, a greenshoe option is used, allowing underwriters to issue additional shares, thereby increasing the supply of shares. This ensures that the stock price does not increase significantly upon listing. Hence, a greenshoe option is used to bring in a level of stability in the stock price of a company issuing an IPO.
Why is a greenshoe option important for various parties involved in an IPO?
First of all, a greenshoe option is beneficial for companies issuing an IPO. With a greenshoe option, companies know that their stock price will be stabilised after the IPO. A relatively stable stock price increases investors’ confidence in a company. Hence, a greenshoe option lays a foundation for a long-term relationship between investors and IPO-issuing companies.
Second, a greenshoe option is beneficial for underwriters, as it helps them reduce the risk of losses because they can buy back shares and stabilise the stock price if the demand for shares is too high.
Third, a greenshoe option helps investors by stabilizing a company’s stock price upon listing. Hence, investors have a fair idea about a company’s true value. In the absence of a greenshoe option, a company’s stock price can witness heightened volatility, which can confuse investors as to its true value. As a result, investors can remain sceptical of the company even in the long run.
Fourth, a greenshoe option is beneficial for both the market and the economy. Excessive volatility is not good for either the market or the economy because it reduces the confidence of market participants. Hence, by ensuring stability in stock prices, greenshoe options perform an important function for the market and the economy.
As investors realize that an IPO has a greenshoe option, they become more confident of stability in its price on listing, which can make them increase their participation in an IPO. Hence, a greenshoe option is important for all the parties involved in an IPO.
Conclusion
For those investors who are keen to explore IPOs to make money, it is important to know whether an IPO has a greenshoe option or not. If it has a greenshoe option, it is possible that its stock price will be stable on listing. However, if it does not have a greenshoe option, its stock price may witness a lot of volatility on listing. Hence, if you are an investor, you should check about this aspect by going through a company’s prospectus. Alternatively, you can even reach out to its investor relations team through social media to check about it.
