Overallotment Definition Purpose and Example

What is Overallotment?

When a company decides to go public, it hires investment banks to underwrite the offering. The underwriters are responsible for pricing and selling the shares to the public. In some cases, the demand for the shares may exceed the supply, resulting in an oversubscribed IPO. This is where overallotment comes into play.

Purpose of Overallotment

The purpose of overallotment is to provide flexibility to the underwriters and stabilize the stock price. By having the option to issue additional shares, the underwriters can meet the excess demand without affecting the price too much. This helps prevent a situation where the stock price skyrockets immediately after the IPO, which could lead to volatility and potential losses for investors.

Additionally, overallotment allows the underwriters to generate additional revenue. When the overallotment option is exercised, the underwriters receive the proceeds from the sale of the additional shares. This can be a significant source of income for the underwriters, especially if the IPO is highly successful.

Example of Overallotment

Definition, Purpose, and Example

The purpose of an overallotment is to provide flexibility to the underwriters and support the market price of the newly issued securities. If the demand for the initial offering exceeds the supply, the underwriters can exercise the overallotment option and sell additional shares. This helps to meet the demand and prevent the stock price from skyrocketing due to scarcity.

Here’s an example to illustrate how an overallotment works:

Company XYZ plans to issue an initial public offering (IPO) of 10 million shares. They enter into an underwriting agreement with an investment bank, ABC Securities, which includes an overallotment provision. The overallotment provision allows ABC Securities to sell an additional 1 million shares if there is high demand for the IPO.

When the IPO is launched, there is a lot of investor interest, and the demand for the shares exceeds the initial supply. ABC Securities exercises the overallotment option and sells an additional 1 million shares to meet the demand. This helps to stabilize the stock price and ensures a successful offering for Company XYZ.