-By Dipika Miglani
Green Shoe Options (GSOs), also known as over-allotment options, were introduced by SEBI (the Securities and Exchange Board of India) in 2003 to help stabilize the price of shares after they are listed in an IPO. Essentially, a GSO gives the company and its underwriters the option to issue extra shares—up to 15% more than originally planned-in order to help maintain the share price during the first 30 days after the stock starts trading. This 30-day period is called the "GSO window."
The main goal of this mechanism is to give retail investors confidence that they can sell their shares at a price close to the issue price, even if the market price fluctuates. From an investor's point of view, an IPO with a Green Shoe Option increases the chances of getting shares and can make the price more stable after the listing, compared to a market without this option.
For the company issuing the shares, the GSO is beneficial because it builds investor trust, which can lead to more demand for shares and a better pricing outcome during the IPO.
Modus Operandi of Green Shoe Option
The green shoe option contributes to providing price stability as the underwriter can increase supply and smooth out the fluctuations occurring in the price of the security. According to the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018, underwriters can sell 15% of the initially offered shares.
In case the price of the share goes down, then underwriters are also authorized to buy back a certain portion of the issue. This is done in order to maintain the investor’s confidence because if an anticipated IPO underperforms in the market, it can create disarray among the investors.
For example, a company plans to issue 10 lakh shares. To exercise the greenshoe option, the company must issue 11.5 lakh shares. The excess share of 50,000 would be considered as the over-allotment. Those over-allotted shares are borrowed from promoters with whom a separate agreement will be signed by the stabilizing agent. Investors who subscribe to the public issue will not be impacted if the company is doing share allotment out of freshly issued 10 lakh shares or the 50,000 shares that they borrowed from the promoters or promoter group. An escrow account is created temporarily that holds certain types of funds or assets until certain pre-conditions are fulfilled in a transaction.
Once the allotment is done, a share is just a share from the investor's perspective. But in the company's case, the whole scenario is completely different. The money that is received for the over-allotment purpose, that money is required to be kept in a separate escrow account.
History of Green Shoe Option
The term “Green Shoe” is technically originated from a company called “Green Shoe Manufacturing Company” now known as Stride Rite Corporation. This method was implemented by the company to stabilize the price of its IPO back in 1960.
Types of Green Shoe Option
Full: In this category, underwriters buy the entire quota of 15% shares and cover their short position, and settle their account in the market without any profit or loss. One of the most prominent examples of a full green shoe option being exercised is the Alibaba Group Holding Limited IPO in 2014. Alibaba's IPO was one of the largest in history, and the underwriters exercised the full green shoe option to purchase additional shares from the company. This helped to stabilize the stock price during a period of high volatility in the market and ensured a successful market debut for the company.
Reverse: This option is exercised when the demand for shares declines or when they want to control the price fluctuation. Here underwriters buy the shares and resell the issuer for a profit. In the case of Facebook's 2012 IPO, Morgan Stanley, as the lead underwriter, utilized the green shoe option to over-allocate shares and meet the high demand. However, when the stock price fell after the IPO, Morgan Stanley was able to exercise the reverse green shoe option to purchase shares at a lower price and sell them back to Facebook at a higher price, mitigating their potential losses.
Benefits of Green Shoe Option
Preventing price drops: If the demand of the shares is more than the external supply, the green shoe option can be exercised by the underwriter to increase the supply of the shares. This will prevent a sudden decline in the price of the share.
Investor confidence: When a price of a stock is stable after an IPO, the confidence of the investors get boosted, the market sentiment gets uplifted and long term investment is attracted.
Risk mitigation: By mitigating the risk of significant price drops, the green shoe option can make the IPO more attractive to investors. Even underwriters get protection against the risk by covering potential short positions and stabilizing the market.
Mitigating Volatility: By absorbing excess demand or selling additional shares to meet unexpected demand, the underwriter can help stabilize the stock price and reduce volatility.
Limitations of Green Shoe Option
Temporary price stabilization: Green shoe option only provides short term support in the early days of the trading. From the perspective of a long-term assistance, green shoe option fails to cater to the stability motive.
Ineffective against over valuation: If there arises a scenario where the IPO is overpriced, this option will not be able to sustain the already inflated price. The forces of demand and supply will bring the stock price back to its fair value.
Limited area of scope: Since underwriters are allowed to issue only 15% of the total shares, there might exist a situation where more than 15% is required to stabilize the shares.
Suggestions for retail investors
While the green shoe option can be a valuable tool for stabilizing IPOs, retail investors should approach it with caution. They should be mindful of its potential implications.
Short-term Volatility: The green shoe option can help stabilize prices in the short term, but it does not guarantee long-term performance.
Market Sentiment: The overall market sentiment and economic conditions can significantly impact the stock price, regardless of the green shoe option.
Diversification: It is rightly said “Never put all the eggs in one basket.” Do not over-invest in a single IPO, especially one with a green shoe option. Diversification is investing money in different investments to reduce risk.
While the green shoe option can provide some level of stability, it is essential to conduct thorough research and consider the specific circumstances of each IPO before making investment decisions.
Conclusion
Green Shoe Option serves as an important stabilizing mechanism during an IPO, benefiting both underwriters and investors. By allowing underwriters to purchase additional shares or repurchase shares in the price fluctuations, this mechanism helps mitigate volatility and prevent sharp fell-offs in stock prices.However, while the Green Shoe Option can offer short-term price stabilization, it has limitations, including its inability to address long-term performance or overvaluation issues. Retail investors should be aware of these factors and exercise caution, especially considering that the Green Shoe Option does not guarantee long-term success. Diversification remains key to managing risk when investing in IPOs, as the broader market conditions and sentiment can ultimately influence stock performance. Overall, the Green Shoe Option is a valuable tool for managing IPO volatility but should be viewed as part of a broader investment strategy, not a guaranteed path to success.
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