Overallotment: Definition, Purpose, and Example

Posted on by user

Overallotment: Definition, Purpose, and Example

What is an overallotment (greenshoe)?

An overallotment, commonly called a greenshoe option, is a provision that lets underwriters sell up to 15% more shares than originally planned in an initial public offering (IPO) or a follow-on (secondary) offering. The option can typically be exercised within 30 days after the offering.

Why it exists

The overallotment serves two main purposes:
* Raise additional capital if demand is stronger than expected (issuer benefit).
* Stabilize the stock price shortly after the offering (market-stabilization tool).

How it works (simplified)

  1. Underwriters initially sell the full allotment plus up to 15% extra shares (they effectively take a short position on the extra shares).
  2. If the market price rises above the offering price, underwriters exercise the greenshoe and buy the extra shares from the issuer at the offering price to cover their short — no loss on covering.
  3. If the market price falls below the offering price, underwriters buy shares in the open market to cover their short position. This buying activity can help support the stock price until the short is covered.
  4. The option can be exercised at any point during the option period (commonly 30 days).

Example

If a company offers 200 million shares at $17 each, a 15% overallotment would allow underwriters to sell an additional 30 million shares. If demand remains high and the market price is above $17, the underwriters may exercise the option to buy those 30 million shares from the issuer at $17.

Pros and cons

Pros:
* Allows the issuer to raise more capital without a separate offering.
* Helps stabilize the stock price in the immediate aftermarket, which can boost investor confidence.

Cons:
* Exercising the option increases share count and dilutes existing shareholders.
* Stabilization techniques are temporary and cannot guarantee long-term price support.

Key takeaways

  • An overallotment (greenshoe) permits up to 15% more shares to be sold than initially planned.
  • It is used to meet excess demand and to stabilize the stock price after an offering.
  • The option is typically exercisable within 30 days and can result in additional capital for the issuer or temporary price support for the stock.