Greenshoe is term relevant to IPOs and refers to a provision that allows the offerring company to issue more stock to public than originally stated. This allows the issuing company to offer more stock if the IPO is going well. This also provides a mechanism by which underwriters can effectively short the stock in order to support the price and stabilize the offering, if needed.

Q. Well, this is a cool sounding buzzword! We know that it somehow kicked in during the FB IPO, but what is it?
A. It’s a adjustment provision that allows the a company to issue more stock an the IPO process than they originally say they will, usually up to 15% more. Normally, people think of it as something that allows a company in a very successful IPO to issue more shares and take advantage of the popularity of the offering. But in the FB IPO, the greenshoe worked differently, to support the price when the shares came under pressure Friday afternoon.

Q. Right, we certainly know this wasn’t one of those IPOs where the share price jumps a mile from the offering price. So how exactly did it work with FB?
A. Initially, FB sold 421mm shares to the underwriters, led by Morgan Stanly. But MS actually had allocated, and sold, 484mm shares on Friday morning. They over-alloted and, therefore were essentially short 63 million shares when trading started.

Q. Hmmm… but, why in the world would underwriters effectively short the stock?
A. It essentially allows them to see how the pricing is going, and then decide what to do. If the stock keeps going up, they can “cover” the short by exercising the greenshoe rights, thus buying more shares from the company to cover. As we said at the top, that’s the normal way you think of it working.

Q. OK, interesting… but what about this case?
A. Here, the price quickly started falling back to the $38 price. MS didn’t want this thing to “break issue” by dropping below $38, so they started buying back in massively, essentially supporting the stock price but also, of course, covering their short. So, that’s how a greenshoe acts to stabalize an IPO’s price: the underwriter just starts buying to cover the effective short. But they couldn’t have taken the risk of being short in the first place, without the ability to buy from the company under the greenshoe option.

Q. Interesting! But one important last question: why in the world is it called a “Greenshoe” option?
A. Ah, because the first time the device was ever used was in the IPO of Green Shoe Manufacturing Company… now called Stride Right.