Greenshoe, or over-allotment clause, is the term commonly used to describe a special arrangement in a U.S. registered share offering, for example an initial public offering (IPO), which enables the investment bank representing the underwriters to support the share price after the offering without putting their own capital at risk. This clause is codified as a provision in the underwriting agreement between the leading underwriter, the lead manager, and the issuer (in the case of primary shares) or vendor (secondary shares). The provision allows the underwriter to purchase up to 15% in additional company shares at the offering share price.
The use of the greenshoe (also known as "the shoe") in share offerings is widespread for two reasons. First, it is a legal mechanism for an underwriter to stabilize the price of new shares, which reduces the risk of their trading below the offer price in the immediate aftermath of an offer—an outcome damaging to the commercial reputation of both issuer and underwriter. Secondly, it grants the underwriters some flexibility in setting the final size of the offer based on post-offer demand for the shares.
Underwriter short-selling and price stabilization
Greenshoe clause
The greenshoe provides initial stability and liquidity to a public offering. However, underwriters of initial and follow-on offerings in the United States rarely use stabilizing bids to stabilize new issues. Instead, they engage in short selling the offering and purchasing in the aftermarket to stabilize new offerings. "Recently, the SEC staff has learned that in the US, syndicate covering transactions have replaced (in terms of frequency of use) stabilization as a means to support post-offering market prices. Syndicate covering transactions may be preferred by managing underwriters primarily because they are not subject to the price and other conditions that apply to stabilization."
Naked short selling and syndicate covering purchases
The only pathway the underwriting syndicate has for closing a naked short position is to purchase shares in the aftermarket. Unlike shares sold short related to the greenshoe, the underwriting syndicate risks losing money by engaging in naked short sales. If the offering is popular and the price rises above the original offering price, the syndicate may have no choice but to close a naked short position by purchasing shares in the aftermarket at a price higher than that for which they had sold the shares. On the other hand, if the price of the offering falls below the original offer price, a naked short position gives the syndicate greater power to exert upward pressure on the issue than the greenshoe alone, and this position then becomes profitable to the underwriting syndicate.
The SEC currently does not require that underwriters publicly report their short positions or short-covering transactions. Investors who are unaware of underwriter stabilizing activity, or who choose to invest in what they perceive to be a stable issue can encounter volatility when the underwriters pause or complete any stabilizing activity. "Cast in the most negative light, price stabilization might be seen as a means of transferring risk to a relatively naïve segment of the investor population."
Reverse greenshoe
A reverse greenshoe is a special provision in an IPO prospectus, which allows underwriters to sell shares back to the issuer.
A reverse greenshoe is used to support the share price in the event that the share price falls in the post-IPO aftermarket. In this case, the underwriter buys shares in the open market and then sells them back to the issuer, stabilizing the share price.
In certain circumstances, a reverse greenshoe can be a more practical form of price stabilization than the traditional method.
The Facebook IPO in 2012 is an example of a reverse greenshoe.
How a regular greenshoe works
- The regular greenshoe is a physically settled offset given to the underwriter by the issuer.
- The underwriter has sold 115% of shares and thus is 15% short.
- The IPO price is set at $10 per share.
- If it falls to $8, the underwriter does not exercise the shoe, instead it buys the shares at $8 in the market to cover his short position at $10. Buying a large block of shares stabilizes the price. The underwriter makes $2.
- If the price rises to $12, the underwriter exercises the shoe, buying shares from the issuer at $10 (minus the underwriting discount) and closing out his short position.
How a reverse greenshoe works
- The reverse greenshoe is for a given amount of shares (15% of the issued amount, for example) held by the underwriter "against" the issuer (if a primary offering) or against the majority shareholder/s (if a secondary offering).
- The underwriter sells 100% of the issued stock.
- The IPO price is set at $10 per share.
- If it falls to $8, the underwriter purchases X number of shares in the market and then exercises the greenshoe, buying the shares at $8 in the market and selling back to the issuer at $10. Buying a large block of shares stabilizes the price, gaining $2 per share.
- If the price rises to $12, the underwriter neither purchases stock nor exercises the shoe.