Greenshoe Options, IPO Pricing, and Planned Capital Needs
Summary
The document explains why a company may not seek to maximize the amount raised in an initial public offering. A greenshoe option gives underwriters flexibility to obtain additional shares if the share price rises after the offering; their overallotment and short position can also help manage early aftermarket volatility. The answer compares this arrangement to airline overbooking, where expected cancellations are balanced against the risk of selling too many seats.
The company’s financing target matters too. The example describes a firm raising enough to repay debt at 5% interest: paying off that debt can increase later earnings per share, while raising twice as much leaves surplus funds that do not produce the same per-share benefit. This is an illustrative explanation, not a general guarantee that extra capital lowers shareholder value. The document also notes that firms may issue shares later if they need more funding.
Key ideas
- A greenshoe option lets underwriters obtain extra shares when the stock rises after an IPO.
- Underwriters may overallot shares and use aftermarket trading to manage initial price volatility.
- A company’s desired IPO proceeds can reflect a specific financing plan, such as repaying debt.
- Extra proceeds may not benefit shareholders as much if they are not put to productive use.
- Later share issuance can provide another source of capital when a company’s needs change.
Tags
Full text
# Raising money in IPOs # Raising money in IPOs When a company goes into an IPO wouldn't they try to make as much money as they can? Then how come the Greenshoe option says that some would try to not issue additional shares just so their share price doesn't raise more money than planned? I mean what kind of situations wouldn't you want to raise more money than keep the share price to the planned price? http://en.wikipedia.org/wiki/Greenshoe ## Answer by user66554 (score 0, accepted) https://quant.stackexchange.com/a/17321 You could compare a Greenshoe option to overbooking a plane: airlines tend to sell more tickets than there are seats in the plane in the expectation that some people will not show up. If they do not oversell then the plane will take off partially empty, which makes it more expensive. But if they oversell too much, then there will be many angry passengers because they can't travel. The underwriters (=airline) oversell the company (=plane), i.e. make short sells such that if investors sell their shares in the aftermarket (=no-show passengers) the price won't drop because the underwriters can close their short sells at a profit. The Greenshoe option serves to protect the underwriters if the prices rise instead they can request additional shares rather than having to close their short sell at a loss at the market. But all this only serves to cover the initial volatility of the price right after the public offering. Now when a company goes public it usually has plans for that money, e.g. expanding in other markets. Consider the case of a company that wants to get rid of a loan costing them 5% interest a year. Now if the IPO made them exactly the amount needed to pay off the debt they could show 5% extra earnings per share the next year. However, if they raised twice the needed amount from the IPO then they would have only 2.5% extra earnings per share. So raising more money than needed dilutes the shareholder value, because the extra earnings gets spread across more shares - and diluted shareholders are unhappy shareholders. Furthermore most companies reserve the right to issue additional shares at a later time in case they need the money. Hence there is no need to make as much money as possible on an IPO (unless you're trying to con the investors) - the point is to make as much money as you need.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.