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.
The fact that the stock market is confounded about what the fair value of the company’s shares is is indicated by too much volatility. It can also hurt investors’ confidence in the company that has come out with an IPO, other than being too volatile.
At times an IPO, companies worry that when their stock first hits the market, it may explode with demand — sending its price through the stratosphere. Thus, companies can implement a greenshoe option so that the host price doesn’t increase significantly.
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 and foremost, an option called greenshoe is useful for the company participating in the IPO. While using greenshoe option companies are aware the price of their stocks will be maintained after the IPO. High stock price stability makes investors gain confidence in a certain company. Therefore, greenshoe option creates the underpinning for a long-term investors IPO-issuing companies interaction.
Second, a greenshoe option is useful for underwriters since it means that they won’t be as likely to lose money since they can repurchase the stocks and calm down an overly enthusiastic market by stabilizing the share price.
Third, a greenshoe option is beneficial to investors especially in the listed company in that it assists in controlling any volatility in the price of the listed company’s stock. Thus, the public has reasonable information on the real value of enterprises. In the absence of a greenshoe option, stock price is characterized by volatility thus entrapping investor in determination of accurate value of the company’s stock. Therefore, the investors can continue to be wary of the firm even in the long-run.
Fourth, a greenshoe option is also desirable for the market and the economy. High fluctuation is unhealthy to the market as well the economy because it results to low confidence among the market players. Thus, contributing the function in the market, and the economy as a whole, greenshoe options help to keep the stock prices stable.
When investors are aware that an IPO has a greenshoe option they gain confidence of stability of the IPO’s price when listed, which can make them scale up their participation in an IPO. Therefore a greenshoe option is crucial to all the stakeholders in an IPO exercise.
Conclusion
For those investors wishing to invest in IPOs’ to make profits it is imperative to find out if the company offering IPO has a greenshoe option or not. If it has a greenshoe option, it means that its stock on listing would likely to be stable or relatively stable. However, when it lacks greenshoe option, its stock price may experience a lot of fluctuations on listing. Therefore, if you are an investor then you go through a company’s prospectus to find about this aspect. Even better, you can inquire from the investor relations team on any of the social media platforms to confirm about it.
