Greenshoes as a Way to Stabilize New Issues and SpaceX

IPOs are difficult operations to carry out, requiring extensive preparation, the involvement of many professionals, and the deployment of sophisticated mechanisms. The SpaceX IPO has caused some noise for several reasons. But in this case, we want to focus on the mechanism colloquially called Greenshoes. We are referring to overallotment options.

The purpose of this mechanism is to stabilize the price for a certain period or amount. Imagine an IPO of 10 shares at $40 each. The company conducting the IPO has at its disposal this mechanism, which materializes by offering subscribers (banks and distributors of the shares participating in the IPO) an option contract for its shares. In our example, the company offers subscribers 1.5 additional shares at $40 each, through an option contract, in addition to the 10 shares the company intends to place on the market.

Thus, we have 11.5 shares in the hands of the subscribers, who will begin selling them to investors (all those seeking exposure to the shares in the primary market), before trading can occur in the secondary market.

Here’s where it gets interesting. The subscribers “allocate” the 11.5 shares to investors, but only buy 10 shares from the company. What we have just described in financial terms is a short position. The subscribers have just gone short 1.5 shares, since the legal basis of short selling is precisely selling something you don’t yet fully own (whether because you borrowed it, it’s a repo, or a loan in kind). In this case, the subscribers allocated 11.5 but only bought 10 (they only own 10 of the 11.5 they sold).

The shares underlying the greenshoes (the options) are those they sold without yet owning.

Later, once trading begins (secondary market), the stock could start at $40 but drop to $38 after a few hours or days. The IPO is falling. And this is when the greenshoes mechanism comes into play. To push the price back up, demand must be increased (buying shares), adding buying power to the market. The subscribers (banks) have these 1.5 shares to buy back—the greenshoes.

In our example, the banks allocated 11.5 shares at $40, then bought only 10 shares from the company at $40, and finally repurchased 1.5 shares during the secondary market session (the buying power intended to lift the stock). Thus, the banks, being short, close their position and end up flat. They do not exercise the greenshoes option. They hold no shares, because remember, it was only an option. And during trading, they did not profit, since they allocated exactly what they bought.

This is a legally authorized way of manipulating a market operation. It is necessary to have mechanisms to stabilize prices in markets so that capital is allocated efficiently and investors internalize the price. For this, subscribers have these options that allow them to stabilize the price at the IPO’s target level.

Moreover, this is a form of due diligence, not for the company conducting the IPO, but for those who invested in the primary market. It is the mechanism to assure IPO investors that their prices will be defended at the levels where they bought. It resembles a guarantee or obligation of means, giving investors confidence that if the price drops, the banks will defend it. They stabilize the price.

When we talk about stabilizing the price, we refer to a limited set of legal rules, where operations are carried out without economic fundamentals, to prevent the price from falling. And, for this reason, banks cannot prevent the asset’s price from rising, since the mechanism protects investors, who expect the stock to rise (banks cannot act against their interests).

But as we saw last Friday with SpaceX, IPOs often rise, not fall. This has been common, especially with highly attractive companies like SpaceX.

Now, if prices rise, theoretically the subscriber banks should not stabilize the price, as their buying power is unnecessary. However, this becomes strange because not necessarily so—Morgan Stanley (among other SpaceX IPO subscribers) exercised 15% of the options allowed by the greenshoes, even when the stock soared well above the $135 opening price.

This may show that the mechanism was used for other purposes, if the bankers foresaw demand; or that they were not entirely sure of the stock’s demand in the market. In any case, such agreements are expected, since bankers must be prepared for any scenario.

This rising-price scenario is the second point of interest. Continuing our example: if the stock opens at $45 and keeps rising, since the banks were short, they should suffer losses (short positions profit when prices fall). But the greenshoes again come into play. Banks do not suffer losses, because this mechanism is an option—they fixed the price in advance at one below market.

Subscribers will analyze whether it is safe that the price won’t fall, mainly by studying order flow contracts, volumes, whether the stock is used as collateral, and if stabilization is unnecessary, they will tell the IPO company they will exercise the option.

The way they avoid losses is by exercising the greenshoes—buying 1.5 shares at $40. Thus, the complete operation consisted of selling 11.5 shares at $40 (allocation), then buying 10 shares from the company at $40, and finally exercising the option at $40 to deliver 1.5 shares. Again, they are flat, with no profit or loss.

This mechanism, offered by IPO companies to banks to make the offering more attractive, benefits IPO investors. As we noted, it is not primarily designed to benefit banks. Banks do not pay for these options (though options usually require payment), nor do they profit initially, whether the stock rises or falls. The option is a stabilization tool without exposing the subscriber to risks that could make the operation unfeasible. It is, in principle, a form of diligence toward IPO investors.

These agreements always fall within freedom of contract, so they may vary slightly from what we explained, adapting to the needs of banks and companies going public. This also allows them to face unpredictable scenarios and equips them with tools if forced to act unexpectedly.

One scenario requiring modification is if the IPO opens at a very low multiple, say $20. In such cases, stabilization cannot occur at $40, because orders with such differentials attract sophisticated investors who could arbitrage, worsening matters. They will still attempt stabilization, but at a lower multiple, abandoning the $40 perspective. They would fulfill due diligence, but at a lower price. In this case, they repurchase the 1.5 shares at, say, $25, materializing the short operation: selling 1.5 shares at $40, repurchasing at $25, profiting $15. The banks benefit from the delta between the short sale and option exercise, while still fulfilling their duty to investors.

This scenario is generally considered legitimate. The only debate usually concerns acts prior to the IPO. Often, banks themselves help set subscription prices, calling and testing investors. Legal conflicts may arise if banks are accused of overvaluing shares to profit from their short positions.

Our second scenario may have occurred with SpaceX. As noted, post-2008 IPOs often achieve large valuations in just a few sessions. This was no exception.

The greenshoes is an option, whatever its ultimate purpose, at the primary market price. If the primary price was too low, or demand too high (raising the price), the option gains value. Thus, banks may allocate only 10 shares at $40, at their own risk (the stabilization obligation applies whether or not they placed the 1.5 options), without allocating the 1.5 shares. Then they buy those 10 shares at $40 from the company. They are flat on those 10 shares. But they retain the option for 1.5 shares at $40. If stabilization proves unnecessary and the stock climbs to $100, banks exercise the option, buy at $40, and sell at $100. That $90 gain is theirs.

The IPO price was too low; the company offered an option at a much lower price; the stock soared; the option was exercised; and the banks pocketed the delta.

This is possible because the stock rose, benefiting investors, so the options were not needed to defend the price. Thus, banks did not breach diligence.

The key issue in this second scenario is whether this constitutes market manipulation. This has been widely debated in the U.S.

Some argue it is not manipulation, because the stabilization price is not fixed—it must adjust as the market sets the price. In our example, we set $40 as the offer and stabilization price, but that need not be so. Financial law often allows decoupling the offer price from the stabilization price. In the U.S., stabilization targets the “stabilizing bid for the security in the principal market” or “the last independent transaction price,” meaning stabilization follows independent orders. The important point, this view holds, is that the subscriber’s order (greenshoes or otherwise) does not intervene beyond what is necessary.

Another argument is that SEC Regulation M does not expressly prohibit selling shares at a higher price once the option is exercised.

Opponents argue that Regulation M’s spirit is to prevent using the option for anything other than covering short sales during allocation. Thus, it would forbid extending participation in the market beyond closing the short. They argue distribution is not closed if options are exercised beyond what is needed to cover shorts. This matters because distribution must be closed before banks can trade the stock for other clients. Banks remain blocked until distribution closes.

The SpaceX case is intriguing for several reasons. First, it may have been entirely reasonable to agree on greenshoes, given current market conditions. The SpaceX offering was anomalous in fundamentals. We mean that the price was not technically determinable, since the valuation was outside any financial parameter; its demand—even with this anomaly in valuation—was impressive; and SpaceX was an exceptionally large private company by normal standards of what a private company is. In other words, it was not foreseeable to arrive cleanly at the correct price for purposes of identifying the offer price together with the stabilization price.

Secondly, these mechanisms are designed to operate precisely when there is no predictive capacity, that is, under the theory of price stabilization. The initial returns of IPOs must show variability, not stability, in order to be stabilized. If we add the particular characteristics of the SpaceX IPO, this is broadly justified. The issue is that, at first, the mechanism sought to protect against price declines (defending investors). But now, even though we have normalized that a stock can grow in such a short time to surprising multiples, stabilization may be required on the upside, so that volatility does not become excessively aggressive. Market sensitivities, especially when retail trading is so widespread, may justify this point.

Thirdly, it is possible to imagine that SpaceX’s subscribers sold the optioned shares at a price higher than their exercise ($135 USD), meaning they did not use the option to close a short position (opened during the primary allocation), but rather to sell them at a higher price in the market. This could be supported by the fact that they foresaw fierce demand for SpaceX shares in the secondary market, provided they were willing to accept the trading lock-up (while not selling those options) for a prudent period that did not jeopardize their relationship with other clients.

Fourthly, it is also entirely possible that the subscribers exercised the option, but not to sell it at a higher price, rather simply to please their clients who subscribed with them (having sold it to them at $135 USD). That is, they used the mechanism as it is theoretically intended. In this scenario, the issue that may arise is that the banks did not charge for the placement of the greenshoes. But they may well have remained in good standing with their other clients, to the point that it was worthwhile to place the greenshoes without charging SpaceX for it.

Finally, let us remember that the greenshoes is an option. This allows us to imagine an endless number of contracts on them, whether during allocation or in the secondary market. Therefore, it is possible that both scenarios we have just modeled do not reflect reality. The legal engineering of this, through freedom of contract as well as public order rules, allows for many more possibilities.