How does an IPO greenshoe work?

Green shoesalsoknown as the green shoe mechanism or green shoe options, is a special provision in the initial public offering (IPO) statement, which allows underwriters to sell more shares to investors than the issuer originally planned, which is legally called an "overallotment right." This release is usually used when companies need more security than expected.

In the IPO statement, the green shoe mechanism allows underwriters to short shares in the issuance of registered securities at the issue price. The scope of operation of the green shoe mechanism is different, but it usually does not exceed 15% of the original circulation.

The green shoe mechanism ensures the stability and liquidity of the public offering. For example, a company chose an investment bank (or consortium, or syndicate) as underwriter and publicly issued 1 million shares through the latter, the price of which was determined by agreement between the company and the buyer. When stocks begin to trade on the open market, the lead underwriter is responsible for assisting in ensuring that shares are traded at or above the issue price.

When the trading price of a public offering is lower than the issue price, the issue is called a "break". This makes the stock will be considered by the customer to be unstable and unsatisfactory, which may further lead to the sell-off of shares and vacillate the purchase of stocks.

To manage this situation, the underwriter can initially short sell to the customer in an excess of 15 per cent (in this case, 1.15 million shares). When the transaction price is determined and the 1.15 million shares are "valid" (that is, the public trading conditions are met), the underwriter can support and stabilize the issue price of the shares at the issue price or lower by buying back 15 per cent of the excess (in this case, 150000 shares).

In doing so, underwriters do not have to take the risk of "long" the additional 15 per cent of the shares in their accounts, as the shares simply "cover" their short positions.

When the issue succeeds, the demand for shares leads to an increase in the price of the stock and remains above the price of the issue. If underwriters close their positions by buying shares on the open market, they will buy stocks at a higher price than they did when they shorted them, thus suffering losses. The green shoe mechanism can play a role in this case, in which the company gives underwriters the right to overbuy at the beginning, allowing them to overbuy up to 15 per cent of the shares at the original issue price. By exercising the green shoe option, the underwriter can close the position by buying the stock at the price of short selling, thus avoiding the loss.

If underwriters are able to buy back all oversold shares at or below the issue price (in support of the share price), they will not be required to exercise any green shoe options. If they can buy back some of the shares at or below the issue price (as the stock price eventually rises and exceeds the issue price), the underwriter will exercise part of the green shoe option to make up for the remaining short position.

If underwriters are unable to buy back any oversold parts at or below the issue price because the stock immediately rises and stops, they will fully assume the 15 per cent short position and exercise 100 per cent of the green shoe option.