Green Shoe Option in IPO: Meaning, Example, And Benefits

A public company will worry about needless price volatility after IPO listing when it files its Initial Public Offering (IPO). For example, if the share price falls on the very same day, it will cause an issue for the company. To stop this from happening, a good mechanism is applied in various IPOs all over the globe - the Green Shoe Option. 

In this detailed guide, we will analyse the green shoe option meaning, the way the green shoe option in IPO functions, and the example and importance of this mechanism in IPO price stabilization.

What Is a Green Shoe Option?

A green shoe option (or just green shoe for short) is a special arrangement in IPO contracts that gives the underwriters the option to sell 15% more shares than what was initially offered to the public.

The additional shares, which are part of this special arrangement, help to stabilise the IPO's price after it goes live, helping to mitigate the potential for excessive volatility. Simply put, a greenshoe is a price-support mechanism for the IPO.

Greenshoe Option Meaning in Simple Terms

The greenshoe option’s meaning is rather simple, especially when you consider that it serves as a safety belt.

• If the demand for the IPO is super high, then the underwriters will sell additional shares.
• If the share price drops after listing, underwriters purchase shares on the open market.
• This purchasing activity supports the price, preventing it from falling too sharply.
• This is why the green shoe option is directly connected to stabilising the IPO price.
  
  

Why Is the Green Shoe Option Important in IPOs?

The IPO market is emotional, and there is a lot of price volatility. This is caused by:

• Over-enthusiasm on the listing day
• Early investors cashing out profits.
• General market sentiment is poor.
• The green shoe option in IPO helps to address this.

Key Objectives:

• Prevent severe price declines.
• Minimise risk for retail investors.
• Promote a more orderly trading environment.
• Enhance the reputation of the IPO.
  
  

How the Green Shoe Option Works (Step-by-Step)

Let’s understand the mechanism clearly:

Step 1: IPO Launch

A company decides to issue 1 crore shares in its IPO.

Step 2: Greenshoe Clause

The IPO document gives the option for underwriters to offer 15% more shares (15 lakh shares).

Step 3: Over-Allotment

The underwriters offer 1.15 crore shares rather than just 1 crore.

Step 4: Price Movement After Listing

Case A: Share Price Decreases

• Underwriters purchase shares from the open market.
• This buying demand pushes the price up.
• These purchased shares will be returned to the issuer.

Case B: Share Price Rises

• Underwriters activate the green shoe option.
• The company officially issues additional shares.
• No market purchasing is necessary.
• This mechanism provides IPO price stabilization for both cases.
  
  

Green Shoe Option in IPO: Practical Example

Assume:

IPO price = ₹100

Shares available = 1 crore

Greenshoe = 15 lakh shares

Scenario 1: Price Falls to ₹90

• Shares are purchased by the underwriters for ₹90.
• This supports the price.
• Investors will experience less of a loss.

Scenario 2: Price Rises to ₹120

• The underwriters, under the agreement, offer for sale the additional shares at the IPO price.
• The company benefits from an increase in demand for their shares.
• The market remains stable.

This example clearly illustrates the protection provided to investors and the company by utilising the green shoe option in IPO.

Role of Underwriters in IPO Price Stabilisation

Underwriters are the main players in the green shoe mechanism.

Some of their obligations are:

• Managing the allotment of additional shares to be sold.
• Supervising the price of shares after they have been listed in the market.
• Purchasing shares if their price declines, or if there is a significant gap.
• Ensuring a smooth and organised trade.

It is impossible to achieve IPO price stabilization without underwriters and green shoe options.

Advantages of Green Shoe Option

Price Stability

It protects against panic selling and extreme drops.

Investor Confidence

A lot of retail investors remain confident when there is some kind of downside risk protection.

Smooth Listing

It helps in avoiding volatility and disorder on the day of the listed trade.

Strong Market Image

It helps in giving an impression of professionalism and the transparency of the company.

Better Long-Term Performance

Stable IPOs tend to do better in the long run.

Green Shoe Option vs No Greenshoe IPO

Feature	IPO With Green Shoe	IPO Without Green Shoe
Price Stability	High	Low
Volatility	Controlled	Very High
Investor Risk	Lower	Higher
Market Confidence	Strong	Weak
Post-Listing Support	Available	Not Available

 

This comparison demonstrates why green shoe options in IPOs are so popular.

Is Green Shoe Option Mandatory?

• The green shoe option is not obligatory. 
• Not mandatory.
• Varies based on the company and underwriter.
• More frequent in larger and more visible IPOs.

However, the majority of new IPOs currently in the works are using green shoes because of how well they support the injunction and stabilisation of the closing IPO price.

Green Shoe Option Limitations  

Although the advantages are numerous, the green shoe option also has some downsides:  

• Cannot correct the price decline due to fundamental issues. 
• Only supports the price for a limited time. 
• Ineffective under extreme market conditions.  
• Needs an experienced underwriter.

Therefore, it is a support mechanism, not a guarantee.

IPOs in India and the Green Shoe Option  

In India, institutions like SEBI regulate the use of the green shoe option in:  

• Mainboard IPOs  
• Significant public sector IPOs  
• High private company IPOs  

When the Indian markets meet the post-listing stability, it has been noted that the IPOs were using the green shoe option more effectively.

Important Information

• The Green shoe option also allows underwriters to purchase an additional 15% of shares.
• Used for price stabilisation after the stock begins trading.
• Benefits issuers & investors.
• Not required, but typical.

When investing in IPOs, always check whether there is a green shoe option in the IPO, as it is important to your investing experience.

Conclusion

The green shoe option remains one of the most effective mechanisms in the IPO ecosystem when it comes to closing price stabilisation and the protection it offers to the investors, ensuring market efficiency.