How Alibaba achieved the world ever largest IPO of $25 billion?

When Alibaba Group Holding Ltd. (BABA) increased the size of its initial public offering yesterday, it used a mechanism that was invented before any American president had yet visited China.

It was February 1963, and a U.S. company called Green Shoe Manufacturing Co. was readying a public offering, managed by investment bank Paine, Webber, Jackson & Curtis. It was a routine deal except for one provision: the underwriters had the option to increase the size of the offering by 15,500 shares.

Over the next 50 years, that mechanism — aimed at taking some of the underwriter risk out of the first day of trading — was used more frequently, and now it’s part of most IPOs. The term “greenshoe” stuck, even if the company, Green Shoe, became Lexington, Massachusetts-based Stride Rite Corp.

In Alibaba’s underwriting agreement, the banks were able to sell 15 percent more stock to investors than they offered through the IPO. That greenshoe amounted to an extra $3.3 billion in proceeds for the Chinese e-commerce company — worth more than any single IPO in the U.S. since Facebook Inc.’s 2012 offering.

Just like today, stocks in the early-1960s were on a tear, and regulators approved the greenshoe as a way of encouraging more companies to tap the public markets, said Richard Sylla, the chairman of the Museum of American Finance and professor at New York University.

‘Overallotment Option’

The term greenshoe never appears in Alibaba’s prospectus. The technique is instead called an “overallotment option.” It gives the underwriters the ability to issue more shares than the original offering size.

If Alibaba’s price declined in the first day of trading, the banks would effectively close their short position by buying shares from the public market to pad — or even reverse — the fall.

As we now know, that didn’t happen. Alibaba’s shares surged 38 percent in their debut.

The greenshoe allowed Alibaba’s banks to buy the extra 48 million shares they sold to investors at the IPO price of $68.

So Alibaba’s underwriters were able to use the overallotment option to increase the IPO size because of the high demand the first day of trading — and make $39.2 million in fees just from the greenshoe, bringing their total to $300 million. They raked in $261.2 million after completing the IPO, according to a regulatory filing.

IPO Arsenal

“Pricing an IPO is still an art, not a science,” said Bruce Foerster, president of South Beach Capital Markets and co-author of the Capital Markets Handbook, who worked in equity issuance on Wall Street from 1974 to 1994. “You need the greenshoe to facilitate the aftermarket price action of the stock. It’s a tool in your arsenal of dealing with the vagaries of an IPO.”

The greenshoe has had staying power because it tends to benefit both the issuer and the underwriter. The issuer either has a cushion for a declining stock, or is able to raise as much as 15 percent more in proceeds if the shares rise.

“Underwriters like the greenshoe to be exercised because they’ve added 15 percent to their revenue and essentially nothing to their costs,” said Jay Ritter, a finance professor, who studies IPOs at the University of Florida in Gainesville.

Alibaba was able to raise $25 billion, including the greenshoe option, compared with $21.8 billion before.

Goldman Sachs Group Inc. served as the stabilization agent for Alibaba’s IPO. Additionally, Credit Suisse Group AG, Deutsche Bank AG, JPMorgan Chase & Co., Morgan Stanley and Citigroup Inc. managed the offering. Bloomberg