Greenshoe

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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. [1] 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). [2] The provision allows the underwriter to purchase up to 15% in additional company shares at the offering share price. [3] [1]

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The term is derived from the name of the first company, Green Shoe Manufacturing (now called Stride Rite), to permit underwriters to use this practice in an IPO. [4]

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. [3]

As an example, a company intends to 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 careful examination of their value and expected worth. When shares begin trading in a public market, the lead underwriter is enabled to help the shares trade at or above the offering price.

When a public offering trades below its offering price, the offering is said to have "broke issue" or "broke syndicate bid". This can create the perception of an unstable or undesirable offering, which can lead to further selling and hesitant buying of the shares. To manage this situation, the underwriters initially oversell ("short") the offering to clients by an additional 15% of the offering size (in this example, 1.15 million shares). When the offering is priced and those 1.15 million shares are "effective" (become eligible for public trading), the underwriters are able to support and stabilize the offering price bid (also known as the "syndicate bid") by buying back the extra 15% of shares (150,000 shares in this example) in the market at or below the offer price. The underwriters can do this without the market risk of being "long" this extra 15% of shares in their own account, as they are simply "covering" (closing out) their short position.

When there is high demand for an offering, it causes the price of shares 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) would now come into play. The company had initially granted the underwriters the ability in the greenshoe clause to purchase from the company up to 15% more shares than the original offering size at the original offering price. By exercising the greenshoe, 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 oversold shares at or below the offering price (to support the stock price), then they would not need to exercise any portion of the greenshoe. 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 price), then the underwriters would exercise a portion of the greenshoe to cover their remaining short position. If the underwriters were not able to buy back any portion of the oversold shares at or below the offering price ("syndicate bid") because the stock immediately rose and stayed up, then they would completely cover their 15% short position by exercising 100% of the shoe.

SEC regulations

The SEC permits the underwriters to engage in naked short sales of the offering. [1] The underwriters create a naked short position either by selling short more shares than the amount stated in the greenshoe, or by selling short shares where there is no greenshoe. It is theoretically possible for the underwriters to naked short sell a large percentage of the offering. The SEC also permits the underwriting syndicate to place stabilizing bids on the stock in the aftermarket. [5] 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." [6]

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. [1]

Risk to investors

The underwriters' ability to stabilize a stock's price is finite both in terms of the number of shares the underwriters short-sold, and the length of time over which they choose to close their positions. "Regulation M defines this type of share repurchase as a syndicate covering transaction and imposes the same disclosure requirements as those imposed on penalty bids. 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." [7]

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." [8]

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. [9]

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. [10]

How a regular greenshoe works

How a reverse greenshoe works

Related Research Articles

The primary market is the part of the capital market that deals with the issuance and sale of securities to purchasers directly by the issuer, with the issuer being paid the proceeds. A primary market means the market for new issues of securities, as distinguished from the secondary market, where previously issued securities are bought and sold. A market is primary if the proceeds of sales go to the issuer of the securities sold. Buyers buy securities that were not previously traded.

<span class="mw-page-title-main">Security (finance)</span> Tradable financial asset

A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any form of financial instrument, even though the underlying legal and regulatory regime may not have such a broad definition. In some jurisdictions the term specifically excludes financial instruments other than equities and fixed income instruments. In some jurisdictions it includes some instruments that are close to equities and fixed income, e.g., equity warrants.

An initial public offering (IPO) or stock launch is a public offering in which shares of a company are sold to institutional investors and usually also to retail (individual) investors. An IPO is typically underwritten by one or more investment banks, who also arrange for the shares to be listed on one or more stock exchanges. Through this process, colloquially known as floating, or going public, a privately held company is transformed into a public company. Initial public offerings can be used to raise new equity capital for companies, to monetize the investments of private shareholders such as company founders or private equity investors, and to enable easy trading of existing holdings or future capital raising by becoming publicly traded.

<span class="mw-page-title-main">Short (finance)</span> Practice of selling securities or other financial instruments that are not currently owned

In finance, being short in an asset means investing in such a way that the investor will profit if the value of the asset falls. This is the opposite of a more conventional "long" position, where the investor will profit if the value of the asset rises.

Underwriting (UW) services are provided by some large financial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liability arising from such guarantee. An underwriting arrangement may be created in a number of situations including insurance, issues of security in a public offering, and bank lending, among others. The person or institution that agrees to sell a minimum number of securities of the company for commission is called the underwriter.

The secondary market, also called the aftermarket and follow on public offering, is the financial market in which previously issued financial instruments such as stock, bonds, options, and futures are bought and sold. The initial sale of the security by the issuer to a purchaser, who pays proceeds to the issuer, is the primary market. All sales after the initial sale of the security are sales in the secondary market. Whereas the term primary market refers to the market for new issues of securities, and "[a] market is primary if the proceeds of sales go to the issuer of the securities sold," the secondary market in contrast is the market created by the later trading of such securities.

Gross spread refers to the fees that underwriters receive for arranging and underwriting an offering of debt or equity securities. The gross spread for an initial public offering (IPO) can be higher than 10% while the gross spread on a debt offering can be as low as 0.05%.

<span class="mw-page-title-main">Securities market</span> Component of the wider financial market

Security market is a component of the wider financial market where securities can be bought and sold between subjects of the economy, on the basis of demand and supply. Security markets encompasses stock markets, bond markets and derivatives markets where prices can be determined and participants both professional and non professional can meet.

A rights issue or rights offer is a dividend of subscription rights to buy additional securities in a company made to the company's existing security holders. When the rights are for equity securities, such as shares, in a public company, it can be a non-dilutive pro rata way to raise capital. Rights issues are typically sold via a prospectus or prospectus supplement. With the issued rights, existing security-holders have the privilege to buy a specified number of new securities from the issuer at a specified price within a subscription period. In a public company, a rights issue is a form of public offering.

A bought deal is financial underwriting contract often associated with an initial public offering or public offering. It occurs when an underwriter, such as an investment bank or a syndicate, purchases securities from an issuer before a preliminary prospectus is filed. The underwriter acts as principal rather than agent and thus actually "goes long" in the security. The bank negotiates a price with the issuer.

<span class="mw-page-title-main">Naked short selling</span> Short-selling practice

Naked short selling, or naked shorting, is the practice of short-selling a tradable asset of any kind without first borrowing the asset from someone else or ensuring that it can be borrowed. When the seller does not obtain the asset and deliver it to the buyer within the required time frame, the result is known as a "failure to deliver" (FTD). The transaction generally remains open until the asset is acquired and delivered by the seller, or the seller's broker settles the trade on their behalf.

A red herring prospectus, as a first or preliminary prospectus, is a document submitted by a company (issuer) as part of a public offering of securities. Most frequently associated with an initial public offering (IPO), this document, like the previously submitted Form S-1 registration statement, must be filed with the Securities and Exchange Commission (SEC).

The underwriting spread is the difference between the amount paid by the underwriting group in a new issue of securities and the price at which securities are offered for sale to the public. It is the underwriter's gross profit margin, usually expressed in points per unit of sale. Spreads may vary widely and are influenced by the underwriter's expectation of market demand for the securities offered for sale, interest rates, and so on.

A special purpose acquisition company, also known as a "blank check company", is a shell corporation listed on a stock exchange with the purpose of acquiring a private company, thus making the private company public without going through the initial public offering process, which often carries significant procedural and regulatory burdens. According to the U.S. Securities and Exchange Commission (SEC), SPACs are created specifically to pool funds to finance a future merger or acquisition opportunity within a set timeframe; these opportunities usually have yet to be identified while raising funds.

A follow-on offering, also known as a follow-on public offering (FPO), is a type of public offering of stock that occurs subsequent to the company's initial public offering (IPO).

Book building is a systematic process of generating, capturing, and recording investor demand for shares. Usually, the issuer appoints a major investment bank to act as a major securities underwriter or bookrunner.

<span class="mw-page-title-main">Stock</span> Shares into which ownership of the corporation is divided

Stocks consist of all the shares by which ownership of a corporation or company is divided. A single share of the stock means fractional ownership of the corporation in proportion to the total number of shares. This typically entitles the shareholder (stockholder) to that fraction of the company's earnings, proceeds from liquidation of assets, or voting power, often dividing these up in proportion to the amount of money each stockholder has invested. Not all stock is necessarily equal, as certain classes of stock may be issued, for example, without voting rights, with enhanced voting rights, or with a certain priority to receive profits or liquidation proceeds before or after other classes of shareholders.

Regulation S-K is a prescribed regulation under the US Securities Act of 1933 that lays out reporting requirements for various SEC filings used by public companies. Companies are also often called issuers, filers or registrants.

The technology company Facebook, Inc., held its initial public offering (IPO) on Friday, May 18, 2012. The IPO was one of the biggest in technology and Internet history, with a peak market capitalization of over $104 billion.

Following is a glossary of stock market terms.

References

  1. 1 2 3 4 "Excerpt from Current Issues and Rulemaking Projects Outline (November 14, 2000)". www.sec.gov. Retrieved 2021-05-30.
  2. ↑ Martin, Alexander, "Line Raises IPO Price Range to Meet Strong Demand" Wall Street Journal, July 4, 2016. Retrieved 2016-07-04.
  3. 1 2 "Greenshoe Options: An IPO's Best Friend". Investopedia. Retrieved 2021-05-30.
  4. ↑ "Company history". Stride Rite. Stride Rite Children's Group LLC. 2012. Archived from the original on 27 May 2012. Retrieved 21 May 2012.
  5. ↑ "Regulation M, Rule 104". University of Cincinnati, College of Law. Archived from the original on November 16, 2011.
  6. ↑ "Presentation on securities law" (PDF). WilmerHale. January 11, 2005. p. 2.[ dead link ]
  7. ↑ Wilhelm Jr., William (1999). Secondary Market Price Stabilization of Initial Public Offerings. Chestnut Hill: Wallace E. Carroll School of Management. p. 3.
  8. ↑ Wilhelm Jr., William (1999). Secondary Market Price Stabilization of Initial Public Offerings. Chestnut Hill: Wallace E. Carroll School of Management. p. 4.
  9. ↑ "Overallotment / Greenshoe Option - Selling Additional Shares in an IPO". Corporate Finance Institute. Retrieved 2021-05-30.
  10. ↑ "Facebook's IPO Sputters". Wall Street Journal. 2012-05-19. ISSN   0099-9660 . Retrieved 2021-05-30.
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