What Does Overallotment Mean?
Overallotment, also known as a 'green shoe option', is the process by which an organization allows its underwriters to sell additional shares during an initial public offering. The details of overallotment are contained in the underwriting agreement of the IPO. Sometimes, underwriters are even allowed to sell 15 percent more shares than what was originally planned for in the IPO. This option, however, must be exercised within 30 days of the date of the IPO.
Divestopedia Explains Overallotment
The idea behind overallotment is to make the most out of the demand for the shares of a particular organization. When a well-known organization goes public, the demand for its shares will be high. Such a scenario allows the organization to raise additional capital through overallotment of shares.
Besides raising capital, overallotment also serves the purposes of stabilizing the price of shares and reducing the loss for underwriters if the price of shares goes below the offer price. When the stock price goes below the offer price for any reason, the underwriters have the option to buy these shares at a lower price. When the supply goes down, the price of shares tends to go up.
Sustained demand for shares due to the company's good performance can raise the price of shares above its offer price. At that time, the underwriters are allowed to exercise their overallotment option in order to buy additional shares at the offer price. This difference makes up for the loss that the underwriters had to take when the value of shares fell below the offer price. However, all this has to happen within 30 days of the date of issue for the overallotment option to be valid. Since this overallotment option helps to stabilize prices during an IPO, it is considered to be an IPO's best friend.
Though the overallotment option provides much price stability for share prices, it is not present in every contract. In general, contracts that are for a limited project, or need only a certain amount of capital, do not contain this clause because it is not needed to cushion out price fluctuations or to raise more money.