Green Shoe Option vs Overallotment: What’s the Difference?

When a company goes public via an Initial Public Offering (IPO), certain measures are put in place to control stock price fluctuations and investor demand. Two of the most popular strategies are the Green Shoe Option and Over Allotment. Although they serve similar functions, there are some distinctions between them.

Let's look at what these terms signify and how they affect investors and companies. 

What Is the Green Shoe Option?

The Green Shoe Option is a provision in an IPO that permits the underwriters to issue and sell up to 15% more of the company's stock at the offer price. This option is used when there is a substantial demand for the shares following their initial offering. If the stock price rises due to significant demand, underwriters can use this option to sell additional shares, stabilising the price.

The name "Green Shoe" refers to the Green Shoe Manufacturing Company, which was the first to adopt this mechanism. Although the concept originated in the United States, it has since become popular in the Indian market. The Securities and Exchange Board of India (SEBI) has also adopted this option to protect the interests of investors and companies.

What Is an Over Allotment?

Overallotment refers to the practice of offering more shares to investors than what the company has initially decided to sell. It acts as a buffer for high-demand situations, ensuring that underwriters have extra shares to sell if needed. When the Green Shoe Option is exercised, the over allotment becomes possible, as the additional shares come into play.

Both the Green Shoe Option and over allotment help stabilise stock prices, but the key difference is that the former is a formal contract allowing extra shares to be sold, while the latter is a result of this provision.

How Do They Work Together?

To understand the relationship between these two terms, it’s essential to consider how they function during an IPO. When an IPO is launched, the company sets a specific number of shares to be sold at a certain price. If investor demand is higher than anticipated, the underwriters may allot more shares than initially available, creating an over allotment.

At this point, the Green Shoe Option comes into play. The underwriters can exercise this option to issue additional shares from the company and then sell them to investors. This mechanism helps avoid excessive price volatility and protects investors from sudden price spikes.

Benefits of the Green Shoe Option and Over Allotment

Both mechanisms offer several advantages for investors and companies. First, they provide stability in the stock price after an IPO, which can otherwise be volatile. For example, if the stock price rises significantly due to high demand, the additional shares from the Green Shoe Option can help bring it back to a reasonable level.

Second, these mechanisms ensure that the company and underwriters can capitalise on high demand without causing unnecessary price inflation. This is particularly useful for Indian investors who are cautious about sudden price hikes in the stock market.

Risks to Consider

While the Green Shoe Option and over allotment provide several advantages, it’s important to be aware of potential risks. If the market is not well understood, retail investors may misinterpret these mechanisms as guarantees of stock price stability. In reality, while they help reduce volatility, they do not entirely eliminate the risks involved in stock market investments.

As an investor with a free trading account, you should be mindful of other market factors like what are options, that can affect the stock price. These include macroeconomic conditions, company performance, and broader market sentiment. Therefore, it’s essential to use these mechanisms as tools for risk management rather than guarantees of profit.

Conclusion

The Green Shoe Option and overallotment are essential tools used during an IPO to stabilize stock prices and meet investor demand. 

While both aim to achieve similar goals, the Green Shoe Option provides the underwriters with a formal right to purchase additional shares, whereas over allotment refers to the act of selling more shares than initially available.