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May 25, 2006

Vonage IPO – How The Bankers May Make a Bundle More Despite the Bust

In some case, the bankers who manage a stock offering can make more money from a bust than a success. It happens when the green shoe drops.

If you look at the front page of the Vonage prospectus, you will see that the banks (called “underwiters”) which took Vonage (called “the company” in prospectus terms) public – Citigroup was the lead bank – earned $31,875,000 in commissions.  Not bad but that’s not quite all.  A little further down on the front page is this line:

“We have granted the underwriters an option to purchase up to 4,687,500 additional shares of common stock to cover over-allotments.”

This is an absolutely standard provision in stock offerings and potentially a very lucrative one.  The over-allotment is commonly known as the green shoe.  The underwriters have thirty days in which they can buy these extra shares at the IPO price.  It’s obvious that, if the stock goes up, the bankers can profit by buying at the IPO price and then selling at the market price.  For example, if Vonage stock were to go up 25% from the offering price, then the over-allotment option would be worth $19,921,875.00 (.25x$17x4,687,500).  Not bad at all.  In the salad days of Bubble 1.0, when stocks typically doubled or tripled postIPO, think what this was worth.  Of course, the company does get extra money by selling the extra shares but has to sell them to the underwriters at the IPO price.

The company I founded, ITXC, had a successful IPO in 1999.  The stock more than doubled from the offering price in the first day.  At some point the underwrites exercised their option.  The company got some more money and the underwriters made more.

But, right now, Vonage stock is going down, not up.  And the over-allotment still may be worth a lot of money to the banks.

In 2000 ITXC had  a secondary offering at about $86 share.  As it turned out, the secondary closed on the day that NASDAQ peaked.  The stock was up for a day or two and then down with the rest of the market.  The bankers didn’t exercise the over-allotment; that is, they didn’t buy any more stock from the company; but they were still in a position to benefit from it.

I’m writing from my experience in Bubble 1.0 so it is possible that things have changed.  However, here’s how it worked.  Often the offering banks sold not only the shares officially offered in the IPO – 31,250,000 shares in the case of Vonage – but also sold the shares they had a right to acquire though over-allotment – all on opening day or soon thereafter.  This is a short sale since the banks don’t actually have the over-allotment shares yet.  But, unlike most short sales, the banks know they won’t lose if the stock goes up because they can always buy the stock to cover the short at the offering price.

So suppose the banks sold the Vonage over-allotment short on IPO day – note that I do NOT know whether or not they did this nor even how to find out.  They would have received almost $80 million for these shares including commissions.  Since they haven’t exercised the over-allotment, just sold the shares which it represents, none of this money goes to the company.

Suppose also that Vonage, instead of going back up continues down, perhaps to $10/share.  The banks can then buy the shares they sold short on the open market for $10 each.  In this case they obviously won’t exercise their option to buy at $17 and the company won’t raise any additional money.  Profit to the banks on the short sale would then be $7/share for a total of $32,812,500.00.  The lower the price of Vonage goes, the more profitable the riskless short sale is to the banks.

I don’t think there is a way to for the bank to both keep the upside potential of the over-allotment AND do the short sale.  They do have to make a choice at some point.  Again, I don’t know what Vonage’s banks did. Either on the upside or the downside, however, the over-allotment can be huge source of bank profit beyond the commission.

It’s all legal.  It’s disclosed right there in the prospectus.  You just have to understand what the over-allotment is and what it means.

Fictional CEO Larry Lazard in my novel hackoff.com: an historic murder mystery set in the Internet bubble and rubble got burned by not understanding how a green shoe might work.  He wasn’t happy.  But fictional trader Sam Gutfreund at fictional bank Barcourt & Brotherson was.  You can read that episode free if you’d like.

Hat-tip to reader Ellen S who told me that the term “green shoe” originated with the IPO of the Green Shoe Company.

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