What is Preferential Allotment? | Definition, Pros and Cons

A method commonly used by companies nowadays to expand its shares in the market is preferential allotment. When shares are made available to a certain set of people and companies (selected through proper procedure) at a pre-decided price, it is known as preferential allotment.

It is an easy and quick way to raise cash and capital. The investors naturally become stakeholders in the company. They can do so at reasonable and moderate prices, instead of having to buy larger shares from the share market. This is usually the incentive offered to them.

Difference between Preferential Allotment and Private Placement

Preferential allotment is quite similar in nature to private placement and the two can often be confused. Both involve a specific set of investors chosen by the company and the offering of shares in private. There is however a very fine difference between the two terms. The differences are enumerated as follows.

  1. In case of private placement, the shares are simply offered by the company to a select group of investors. In case of preferential allotment, shares are freshly issued for this purpose.
  2. The documents and laws governing the two are widely different, as preferential allotment does not require the articles of authorization and valuation reports necessary for private placement.

Different aspects of Preferential Allotment

  1. This can be done after a resolution is made and the motion is passed by the majority of the existent shareholders of the company.
  2. There are minimum pricing guidelines and other laws determining which people or companies may be eligible, how many shares should be issued, and at what price.
  3. There is also a cap on the number of allotted investors that can be chosen at once, usually not more than fifty.
  4. The securities listed are shares and equities which include fully or partly convertible debentures, or any shares that may be turned to equities in the future.

Advantages of Preferential Allotment

  1. A recurrent problem of most economies is that of under-investment, and one of the prominent ways to resolve the same is through preferential allotment.
  2. Shares can be bought by those who are not comfortable with prices at the stock market, and they usually benefit inevitably with any increase in the values of common shares.
  3. It is an easy and generally risk-free way for companies to raise necessary capital without having to borrow from banks and risking its assets.

Disadvantages of Preferential Allotment

  1. Preferential shareholders do not enjoy the same rights (such as voting rights) as the existing equity shareholders, and thus they never can be on par.
  2. Before the minimum pricing limit was set and other guidelines were in place, companies were known to price otherwise financially lucrative shares at exorbitantly high prices.
  3. Promoters have been frequently known to make preferential allotments to themselves and reap the benefits of the same, while depriving genuine and interested investors.
  4. Preferential shareholders actually have claim to the company’s assets, which becomes undesirable on the part of the company.
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References

  1. http://pages.stern.nyu.edu/~msubrahm/papers/Pref%20Allot.pdf
  2. https://journals.sagepub.com/doi/abs/10.1177/0256090915590332
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