In my article 'Green Shoe Option - An IPO's Best Friend" discussed on 22nd November 2012, I introduced you to a price stabilization mechanism and its importance during and IPO. In today's article I will discuss with you on 'How Green Shoe Option Works'
Price Stabilization
This is how a greenshoe option works:
The underwriter works like a dealer, finding buyers for the shares that their client is offering.
A price for the shares is determined by the sellers (company owners and directors) and the buyers (underwriters and clients). When the price is determined, the shares are ready to be publicly traded. The underwriter has to ensure that these shares do not trade below the offering price. If the underwriter finds there is a possibility of the shares trading below the offering price, they can exercise the greenshoe option.
In order to keep the price under control, the underwriter oversells or shorts up to 15% more shares than initially offered by the company.
For example, if a company decides to publicly sell 1 million shares, the underwriters (or "stabilizers") can exercise their greenshoe option and sell 1.15 million shares. When the shares are priced and can be publicly traded, the underwriters can buy back 15% of the shares. This enables underwriters to stabilize fluctuating share prices by increasing or decreasing the supply of shares according to initial public demand.
If the market price of the share exceeds the offering price that is originally set before trading, the underwriters could not buy back the shares without incurring a loss. This is where the greenshoe option is useful: it allows the underwriters to buy back the shares at the offering price, thus protecting them from the loss.
If a public offering trades below the offering price of the company, it is referred to as a "break issue". This can create the assumption that the stock being offered might be unreliable, which can push investors to either sell the shares they already bought or refrain from buying more. To stabilize share prices in this case, the underwriters exercise their option and buy back the shares at the offering price and return the shares to the lender (issuer).
Such an option which was first used by the company Green Shoe (because of which it was named as Green shoe Option) is used by many companies outside India during their IPO process but is not a big hit in India. Statistics speaks of itself when we read that from 2003 to 2011, 365 IPO's were introduced in India out of which only 18 companies opted for this option which is less than 5% of the total public offerings made till today. Some of the participants in this include the IT giant TCS and Deccan Chronicle Holdings Ltd. in the year 2004, Cairn India Ltd. in 2006, Idea Cellular Ltd. in 2007, Indiabulls Power Ltd. in 2009.
During various researches done on this particular topic, researchers have considered various reasons on why Indian companies may not opt for the price stabilization mechanism, some concerns which sounded valued to me are
1) The issues where GSO is opted may not indicate the correct share prices and it will deprive “Value Investor” from purchasing shares from other investors when the price falls.
2) The legal and regulatory compliances are burdensome, due to this, the issuer companies and merchant bankers are not ready to take additional responsibility.
A survey conducted by The Economic Times said that a typical response was “Unlike in the US, SEBI does not permit merchant bankers to make money in trading. They will have to buy the stock if the price falls below the offer price, but they are not allowed to sell even if the stock value goes up. We are required to stabilise the price around the offer price for which we get a fixed fee”
I believe awareness should be conducted among the companies, underwriters, merchant bankers and investors about the importance and benefits of having GSO included in an IPO process.
SEBI being the regulator of the primary and secondary market may make GSO a mandatory clause in order to benefit the Investors and build their confidence in participating in the Primary market.
Price Stabilization
This is how a greenshoe option works:
The underwriter works like a dealer, finding buyers for the shares that their client is offering.
A price for the shares is determined by the sellers (company owners and directors) and the buyers (underwriters and clients). When the price is determined, the shares are ready to be publicly traded. The underwriter has to ensure that these shares do not trade below the offering price. If the underwriter finds there is a possibility of the shares trading below the offering price, they can exercise the greenshoe option.
In order to keep the price under control, the underwriter oversells or shorts up to 15% more shares than initially offered by the company.
For example, if a company decides to publicly sell 1 million shares, the underwriters (or "stabilizers") can exercise their greenshoe option and sell 1.15 million shares. When the shares are priced and can be publicly traded, the underwriters can buy back 15% of the shares. This enables underwriters to stabilize fluctuating share prices by increasing or decreasing the supply of shares according to initial public demand.
If the market price of the share exceeds the offering price that is originally set before trading, the underwriters could not buy back the shares without incurring a loss. This is where the greenshoe option is useful: it allows the underwriters to buy back the shares at the offering price, thus protecting them from the loss.
If a public offering trades below the offering price of the company, it is referred to as a "break issue". This can create the assumption that the stock being offered might be unreliable, which can push investors to either sell the shares they already bought or refrain from buying more. To stabilize share prices in this case, the underwriters exercise their option and buy back the shares at the offering price and return the shares to the lender (issuer).
Such an option which was first used by the company Green Shoe (because of which it was named as Green shoe Option) is used by many companies outside India during their IPO process but is not a big hit in India. Statistics speaks of itself when we read that from 2003 to 2011, 365 IPO's were introduced in India out of which only 18 companies opted for this option which is less than 5% of the total public offerings made till today. Some of the participants in this include the IT giant TCS and Deccan Chronicle Holdings Ltd. in the year 2004, Cairn India Ltd. in 2006, Idea Cellular Ltd. in 2007, Indiabulls Power Ltd. in 2009.
During various researches done on this particular topic, researchers have considered various reasons on why Indian companies may not opt for the price stabilization mechanism, some concerns which sounded valued to me are
1) The issues where GSO is opted may not indicate the correct share prices and it will deprive “Value Investor” from purchasing shares from other investors when the price falls.
2) The legal and regulatory compliances are burdensome, due to this, the issuer companies and merchant bankers are not ready to take additional responsibility.
A survey conducted by The Economic Times said that a typical response was “Unlike in the US, SEBI does not permit merchant bankers to make money in trading. They will have to buy the stock if the price falls below the offer price, but they are not allowed to sell even if the stock value goes up. We are required to stabilise the price around the offer price for which we get a fixed fee”
I believe awareness should be conducted among the companies, underwriters, merchant bankers and investors about the importance and benefits of having GSO included in an IPO process.
SEBI being the regulator of the primary and secondary market may make GSO a mandatory clause in order to benefit the Investors and build their confidence in participating in the Primary market.
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