Green Shoe Option
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Formally known as an "over-allotment option," a greenshoe is the term commonly used to describe a special arrangement in a share offering, for example practical example of green shoe option initial public offering IPOwhich enables the investment bank representing the underwriters to support the share price after the offering without putting their own capital at risk.
The option 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 term is derived practical example of green shoe option the name of the first company, Green Shoe Manufacturing now called Stride Rite Corporationto permit underwriters to use this practice in an IPO.
The use of greenshoe options in share offerings is now widespread, for two reasons: Secondly, it grants the underwriters some flexibility in setting the final size of the offer based on post-offer demand for the shares. The greenshoe option provides stability and liquidity to a public offering. As an example, a company intends practical example of green shoe option sell one million shares of its stock in a public offering through an investment banking firm or group of firms, known as the syndicate which the company has chosen to be the offering's underwriters.
Stock offered for public trading for the first time is called an initial public offering IPO. Stock that is already trading publicly, when a company is selling more of its non-publicly traded stock, is called a follow-on or secondary offering.
The underwriters function as the brokers of these shares and find buyers among their clients. A price for the shares is determined by agreement between the company and the buyers. When shares begin trading in a public marketthe lead underwriter is responsible for helping to ensure that the shares trade at or above the offering price. When a public offering trades below its practical example of green shoe option price, the offering is said to have "broke issue" or "broke syndicate bid".
This creates the perception of an unstable or undesirable offering, which can lead to further selling and hesitant buying of the shares. When the offering is priced and those 1. When the offering is successful, demand for shares causes the price of the stock to rise and remain above the offering price. If the underwriters were to close their short position by purchasing shares in the open market, they would incur a loss by purchasing shares at a higher price than the price at which they sold them short.
The greenshoe over-allotment option would now come into play. By exercising their greenshoe option, the underwriters are able to close their short position by purchasing shares at the same price for which they short-sold the shares, so the underwriters do not lose money. If the underwriters are able to buy back all of the practical example of green shoe option shares at or below the offering price to support the stock pricethen they would not need to exercise any portion of practical example of green shoe option greenshoe option.
If they are able to buy back only some of the shares at or below the offer price because the stock eventually rises higher than the offer pricethen the underwriters would exercise a portion of greenshoe option to cover their remaining short position. The SEC permits the underwriters to engage in naked short sales of the offering. The underwriters create a naked short position either by selling short more shares than the amount stated in the greenshoe option, or by selling short shares where there is no greenshoe option.
It is theoretically possible for the underwriters to naked short sell a large percentage of the offering. Instead, they engage in short selling the offering and purchasing in the aftermarket to stabilize new offerings. 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. The only option 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 option, 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 option alone, and this position then becomes profitable to the underwriting syndicate.
The underwriters' ability to stabilize a stock's price is finite both in terms of the number of practical example of green shoe option the underwriters short-sold, and the length of time over which they choose to close their positions. Consequently, investors need not be informed that an offering is, or will be, stabilized by way of a syndicate short position. Rather, investors need only be exposed to language indicating that 'the underwriter may effect stabilizing transactions in connection with an offering of securities' and a characterization of possible stabilization practices in the 'plan of distribution' section of the prospectus.
The SEC currently does not require that underwriters publicly report their short positions or short-covering transactions. Investors who are unwary of underwriter stabilizing activity 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.
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