An initial public offering (IPO) is an important milestone for a company as it transitions from being privately held to becoming a publicly traded entity. During an IPO, shares of the company are offered to the public for the first time, allowing them to become shareholders and participate in the company's growth.
When a company plans to mobilize funds from the public, it typically appoints an underwriter, which is an investment bank (or group of firms known as the syndicate). The role of the underwriter is to assist the company in navigating the complexities of the IPO process and ensuring its successful execution.
During the IPO process, underwriters conduct thorough due diligence on the company to assess its financial health, operations, and prospects. This helps them determine the IPO price, valuation, and potential risks associated with the offering.
The underwriter plays a significant role in the preparation of the Draft Red Herring Prospectus (DRHP) document for the company. The DRHP is a preliminary registration statement that provides detailed information about the company, its business operations, financials, risks, and other relevant disclosures to potential investors.
The document also provides details on how a company intends to utilize the funds raised from the public. Generally, companies may allocate the funds for various purposes, such as expanding their current business operations, venturing into new business areas, or addressing existing debts.
Once the DRHP is prepared, it needs to be filed with the Securities Exchange Board of India (SEBI) for review and approval. The regulatory body reviews the document to ensure that it complies with the disclosure requirements and guidelines for conducting an IPO.
Meanwhile, in the DRHP document, there is information included about the 'oversubscription' option or 'Greenshoe' option in case the shares offered in the IPO receive higher demand than the available supply.
In this article, we will explore the significance of the 'Greenshoe' option in more detail.
What is the Greenshoe option?
Once the underwriter completes all the necessary preparations for launching an IPO, the shares are typically made available for subscription by investors. This process is known as the subscription period or the offering period. During this period, interested investors have the opportunity to place orders to purchase shares of the company being listed.
During the subscription process, two scenarios can arise: oversubscription and undersubscription. In the case of oversubscription, the company receives an overwhelming response from investors, with the bids exceeding the actual number of shares available.
This indicates a high demand for the IPO.
On the other hand, if the company faces undersubscription, it means that the bids received are for lesser shares compared to the number of shares offered.
Let's focus on the oversubscription scenario. When an IPO is oversubscribed, it indicates strong demand for the shares, which can push the share price above the offering price. This can create a situation where the shares trade at a premium in the secondary market.
To address this, underwriters often employ a risk management mechanism called the "oversubscription' option or "over-allotment" option.
The "over-allotment" option or Greenshoe option allows the underwriters to sell an additional 15% of shares (over and above the original offering size) to investors. This overselling provides underwriters with the flexibility to meet the excess demand in case the IPO is oversubscribed.
The purpose of the this option is to ensure that there is sufficient liquidity in the market for the newly listed shares and to stabilise the stock price during the initial trading period.
By increasing the supply of shares available for purchase, this option helps meet the market demand and reduces the chances of excessive price volatility after the shares being listed in the secondary market.
The origin of its name
The term "Greenshoe" originated from the Green Shoe Manufacturing Company (now known as Stride Rite Corporation), which was the first company to use this option in an IPO.
In an attempt to stabilise the stock price and provide flexibility in aftermarket trading, the underwriters of the IPO suggested including an option to sell additional shares in case of oversubscription.
To commemorate this innovative feature, the underwriters named it after the Green Shoe Manufacturing Company. Over time, the term "Greenshoe option" became synonymous with the overallotment option, referring to the mechanism that allows the underwriters to sell additional shares in an IPO if there is strong demand from investors.
How does the Greenshoe option work?
Let us imagine, ABC Group, a technology company that is experiencing significant growth, decides to raise funds by going public through an initial public offering (IPO). To ensure a smooth and successful IPO, ABC Group enlists the support of an investment banking firm that serves as the underwriter for the offering.
ABC Group initially instructed the underwriter to sell 500 million shares at a price of ₹200 apiece, but the underwriter sold 575 million shares to investors, which is 15% more than the initial allocation. This creates a short position of 75 million shares.
The underwriter is able to oversell the shares because, as part of the IPO process, the company grants the underwriter the option to purchase an additional 15% of shares to accommodate the excess demand from investors.
If the shares of ABC Group perform well and trade at ₹250 apiece, above the IPO price on the listing day, the underwriter exercises the Greenshoe option. This means the underwriter buys back the additional shares from the company at the original issue price of ₹200, effectively closing their short position.
On the other hand, if the shares trade below the IPO price at 180 apiece, the underwriter will cover their short position by purchasing shares at a lower price from the secondary market. This helps the underwriter stabilise the price of the shares and prevent significant declines.
By exercising the Greenshoe option, the underwriter manages the excess demand and stabilises the share price. Overall, the Greenshoe option provides flexibility and support to the underwriter during the IPO process.
Can the Greenshoe option be used in Offer for Sale?
Yes, the Greenshoe option can be used in an Offer for Sale (OFS) as well. An Offer for Sale is a method through which existing shareholders, such as promoters or institutional investors, sell their shares to the public. It provides an opportunity for these shareholders to divest their holdings and allows new investors to enter the company.
Similar to an IPO, the Greenshoe option can be incorporated in an Offer for Sale to manage the supply and demand dynamics of the shares being offered. If there is high demand for the shares during the OFS process, the underwriters or syndicate members can exercise the Greenshoe option to sell additional shares.