"Appeals Court Concludes That IPOs Are Legal"

Matt Levine at BloombergView:

Here’s a thing that happens. When a company goes public, it sells some shares to the underwriters, and the underwriters sell more shares to the public. Let’s say the company sells 100 shares, for $10 each. The underwriters will sell 115 shares, for $10 each, and give the company $1,000 (less fees).

The underwriters will keep the other $150 for themselves. They have bought 100 shares and sold 115, so they are short 15 shares. If the stock price goes down over the next few days, they use some or all of that $150 to buy the stock, so it doesn’t go down too fast. This is called “stabilization.” The underwriters’ buying helps keep the stock price close to the IPO price. People think that is good.

On the other hand, if the stock goes up after the IPO -- which is more common -- the underwriters don’t buy back those 15 shares in the market. (That would be expensive.) Instead, they give the company the $150 they kept (less fees), and get back 15 more shares at the IPO price of $10 each, which they use to close out their short position. This is called “exercising the greenshoe,” for historico-silly reasons. The reason that the company sells the underwriters 15 more shares at $10, even though the stock is now trading at $12 or whatever, is that the underwriting agreement for the IPO included an “overallotment option,” or “greenshoe,” obliging the company to sell the banks 15 more shares, any time in the (usually) 30 days after the offering, at the deal price, at the banks’ option.

The point of the greenshoe is to reduce the banks’ risk on stabilizing the deal. The underwriters buy 100 shares and sell 115, but they aren’t really short those 15 shares: The greenshoe option lets them buy them back at the deal price. So if the stock price goes up -- as, again, it usually does -- they don’t lose any money. If the stock price stays flat, and the underwriters buy back more shares at $10 to prevent it from going lower, they also don’t lose any money. (They sell at $10 and buy at $10.) But if the stock goes down a lot before the underwriters can stabilize it, then they make money: They sell those 15 shares at $10, and buy them back at $9 or $8 or whatever.

Occasionally you will find people who think all of this is very suspicious, because it kind of looks like the banks make more money from bad IPOs. If you underwrite a deal at $10, and the stock immediately falls to $5, then you make a lot of money buying in your short position. That seems like a bad set of incentives. On the other hand, the banks also have lots of incentives the other way, and in practice you more often find people complaining about underpriced IPOs that go way up on their first day of trading.

But Facebook Inc.’s public offering in 2012 is one notable and controversial case of a big IPO where the underwriters made a lot of money because the price went down....MORE