The day of the IPO is finally here this is when it will be labeled a success or hopefully not a failure.
Investment bankers generally prefer a stable, slightly positive performance in the first few days of trading.
Why?
If the IPO is sold at a price that turns out to be too high, investors will be disappointed. Many of them could consider abandoning the stock, creating immediate selling pressure because more shares would be available on the market, driving the price even lower and that’s the last thing anybody wants. On the other hand, if the stock price skyrockets moments after trading, that indicates investment bankers didn’t value the company properly and the founders left a significant amount of money on the table.
So to try and prevent these situations, the investment bank responsible for the IPO makes a stabilization effort which comprises supporting the share price in the after market. But before I explain how stabilization works, it would be better to introduce the concept of Overallotment. A little-known secret is that on the day of the IPO, the investment bank sells more shares than it has underwritten. That is, it sells shares it doesn’t own.
In this context, underwriting means buying the shares from the listed company to resell to investors immediately. So the bank sells the shares it has underwritten to investors, plus additional shares hence the term over-allotment.
Of course, this creates a short position for the shares sold but not owned. The investment bank will need to go to the market and buy the borrowed shares to give them back to company ownership. This will be excellent protection against a falling stock price.
A willing buyer.
In this case, the bank usually helps balance the market price, absorbing downward selling pressure. At the same time, this position could represent a significant market risk for the investment bank. Suppose the share price rises on the day of the IPO or a few days afterward. In that case, the investment bank will lose a considerable amount since it sold the shares at the opening price, but still needs to buy shares on the market to give them back to company ownership. Buying shares when the price is high and selling when it’s low isn’t the preferred business for investment bankers.
So an additional mechanism must be implemented to do this. A call option gives the investment bank the right, but not the obligation to purchase shares at a given price. In most cases, the issuer grants the investment bank a free call option. We’ll introduce call options and their respective terminology later in the program, but please consider the following for now. If the price goes up, the investment bank could exercise its call option and buy shares from company ownership at the same price it sold to the market.
This call option is frequently referred to as Green Shoe, a reference to the technique used for the first time for the IPO of the company Green Shoe.
Okay, perfect.
So if the price goes up, the bank exercises its green shoe call option, buys the shares from ownership, and thus gives back the over-allotted shares to the issuing company. On the other hand, if the price of shares goes down after listing, the bank would buy shares on the market, creating a positive difference concerning the price it paid initially and making a nice profit margin.
Of course, buying shares helps stabilize the market price in this situation too. This is how investment banks help listed firms stabilize their trading price in the first few days of trading.
Greenshoe explained by a practical example
Company A is about to go public.
Investment Bank B is hired to execute the IPO.
To prevent significant price fluctuations on the first day of trading, Company A gives Investment Bank B the overallotment option (‘greenshoe’ option). It consists in allowing Investment Bank B to buy a certain portion of Company A shares (equal to the amount of over-allotted shares) at a pre-agreed price, which usually coincides with the IPO price. Let’s imagine that this price is $100.
If Investment Bank B exercises the call option, it will purchase shares from Company A’s shareholders at a pre-agreed price.
Based on this, Investment Bank B will sell to investors (the public) more shares than Company A initially intended to sell. We should remember that this creates a short position for Investment Bank B with respect to the shareholders of Company A. The bank sold more shares than it had underwritten, and hence after the IPO it needs to return these shares to Company A’s shareholders. Please pay attention that overallotment happens during the book-building process and materializes when the company’s shares start trading on the stock exchange.
In that moment, we can have one of the following scenarios:
Scenario 1: Company A’s share price goes up. Let’s say to $120
Investment Bank B sold more of Company A’s shares and it needs to return these shares to the firm’s shareholders.
However, if the bank buys these shares in the open market it would sustain a loss, right? Investment banks don’t like that. They sold the shares at $100 and now they have to buy them at $120.
Fortunately, investment bankers were given the ‘greenshoe’ option, which allows them to buy shares from shareholders at a pre-agreed price (coinciding with the IPO price of $100) Hence the money collected by bankers for the extra amount of shares sold during the IPO (overallotment) will be sufficient to buy the same amount of shares by exercising the ‘greenshoe’ option. This neutralizes the short position.
At the end of the day, the outcome is that Company A’s shareholders sold more shares to the public.
Scenario 2: Company A’s share price declines to $80
This is why the ‘greenshoe’ option exists in the first place. Bankers want to do everything in their power to prevent a loss of trading value in the first few days after the IPO.
The idea is that many investors will get a bitter taste and will probably sell their stocks, which would result in additional downward pressure for an already decreasing price.
So, here’s what would happen in this scenario.
Investment Bank B sold more of Company A’s shares and it needs to return these shares to the firm’s shareholders.
The good thing is that the current stock price allows bankers to start buying shares in the open market at $80. This helps stabilize the price and hopefully drives it up to the initial value of $100 (because extra demand for shares is created).
In the meantime, bankers were able to make a nice profit given that they sold the overalloted shares at $100.
They will be able to return the overalloted shares to company A’s shareholders and the ‘greenshoe’ option is not exercised in this scenario.
