Company Share Transfer

Preferential Allotment Of Shares: Advantages & Disadvantages

Preferential Allotment

For many businesses, raising capital is an essential step on the road to long-term stability and success. Every endeavour needs an infusion of cash during the launch phase and other operating stages, regardless of whether you are a start-up idea, a serial entrepreneur, or an experienced businessman. Despite the fact that many firms are initially bootstrapped, there is always a need for money to support the business. Funding can help an organisation as it secures chances for development, expansion, and sustained relevance in the future. 
The Companies Act 2013[1] allows businesses to acquire money through employee stock options, right issues, preferential allotments, and initial public offerings. One of the most effective ways to raise money is through preferential allocation. Let us examine the concept of preferential allotment of shares and its advantages and disadvantages.

Preferential Allotment of Shares

Preferential allocation describes the bulk issuance of freshly issued shares by an organisation to investors, companies, and other parties at a predetermined price. A corporation would typically give preferential consideration to those who want to purchase a strategic position within the organisation.

A technique to distribute a large number of new shares preferentially to a certain set of people, investors, or venture businesses. Any business can choose to use the preferential allotment of securities process, whether private, public, listed, or unlisted. Companies opt for this strategy since it is one of the quickest ways to expand capital and the number of shares in the company. When the company is wound up, the holders of preferential shares have the right to receive payment before the common shareholders. The cost of the issue is predetermined. 

A corporation issues such shares in favour of investors and venture capitalists who want a larger ownership stake in the business and can later increase the company’s worth. It may also be an opportunity for stockholders who could not purchase shares at the first public offering. It may be advantageous for both the business and the stockholders. It is because the business can raise a sizable amount of capital, improving the cash flow through the organisation and providing investors and shareholders with a larger stake in the business.

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Reasons for the Company’s Preferential Allotment of Shares 

There are specific reasons from the company’s side for the preferential allotment of shares. Some of them are:

  • Assist the business in obtaining equity involvement.
  • To aid the business in raising money.
  • The flow of capital into the economy is increased by preferential allocation.
  • To give potential investors, promoters, financial institutions, suppliers, or customers a chance to grow their stake in the business.

Regulatory Framework that Governs Preferential Allotment

Understanding the rules governing preferred share allocation is important to avoid privilege misuse.

The Companies Act of 2013 – Section 62 (Section 81 of the Companies Act of 1956)

The clause addresses the further issue of the share capital. The provision stipulates specific groups of people that businesses must approach to raise additional capital: shareholders of the company who, as of the offer date, hold equity shares and the offers made via notice specifying the number of shares offered, time limits not to exceed thirty days, rights to renounce shares offered in favour of any person and disposition of shares to employees under the Employees Stock Plan if the person rejects the offer. Such notice shall be given by registered or express mail or by any electronic means. Debentures or loans from any firm, government, or financial institution are not covered by this clause.

The Companies Act 2013 – Section 42

The section specifies how to make a private placement offer or invitation to subscribe for securities. It specifies that the offer must be extended to not more than fifty people, excluding those covered under employee stock options laws. For the purposes of this section, a private placement is any offer of securities or invitation to subscribe for securities made by a firm through the issuance of a private placement, subject to the fulfilment of the conditions outlined in the applicable section. Such a requirement requires payment via bank transfer or demand draught rather than direct cash. Such allotment must be done within six months of the receipt of the application money.

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Companies (Share Capital and Debentures) Rule, 2014, Rule 13

The rule establishes the terms and procedures for issuing shares under Sections 62 and 42 of the Companies Act of 2013. The shares can only be issued once the board has approved them with a special resolution at a board meeting. The offer or allocation must follow the terms of Section 42. More than two members must receive the preferential offer. A registered valuer is not required to determine the price for a preferential offering by a listed firm. The rule also defines a preferential allocation as issuing shares or other instruments to a chosen group of persons. However, it excludes sweat equity shares, rights issues, and public offerings. The same needs to be permitted by the articles of association and approved by a special board decision. 

Advantages of Preferential Allocation

The corporation benefits from preferential allotment of shares in numerous ways. Preferential Allotments have the following benefits:

No Charges: The first benefit is the absence of a charge on assets. Shares and convertible securities are available through preferential allocation. Unlike debentures, the shares do not place a levy on the assets. Furthermore, maintaining the assets at risk is not a requirement for preferential allocation. As a result, it is advantageous for both the companies and the current shareholders.

Investors Get Additional Benefits: Shareholders with preference shares may exchange their convertible shares for a predetermined number of common shares. The shareholder may be eligible to receive additional dividends if the company successfully exceeds a certain profit threshold. It is advantageous, particularly if the price of common shares rises. This particular sector of preference shares is low risk and provides additional benefits as an investment instrument to earn long-term income. It is a great opportunity for all of the current investors and shareholders.

Preference Shareholders Have A Prior Claim On Business Assets: Preference shareholders may have a stronger claim to the company’s assets in the event of bankruptcy or liquidation. Compared to the common shareholder, this reduces the investment risk to a manageable level. The preferred stockholders receive a yearly dividend payout that is guaranteed. The preferred shareholders will receive appropriate compensation for their investments if the company decides to cease operations.

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Increasing borrowing capacity: The firm’s ability to borrow money is increased via preferential allocations, which is the last benefit. It lets them make room for non-convertible debentures and loans, which lowers the debt-to-equity ratio.

No Dilution for existing shareholders – Because the business does not give preference shareholders voting rights, the issuance of preference shares does not reduce the influence of current equity shareholders. Preference shareholders invest their money with a fixed dividend percentage but are not granted control.

Disadvantages of Preferential Allotment

Every good thing has a drawback, and preferential allocation is no different. It has both benefits and drawbacks. Understanding the process’ limitations is a crucial element:

Damage to the company’s reputation: While failing to pay a defined amount of dividends or dividends on a yearly basis may not result in legal repercussions, it can be detrimental to a company’s reputation. An investor won’t buy a business or securities that won’t generate future profits. Additionally, it may have an impact on the company’s reputation while borrowing money. This is because lenders will only offer to finance if they are confident the company will pay back the entire amount.

Lack of Voting Rights: Investors do not have the same level of ownership or voting rights as common shareholders when investing money under preferential allotments. Additionally, it might stop them from putting their savings into such a plan. From the standpoint of the investor, preferred shareholders are not subject to the same obligations as equity shareholders. The preferred shareholders will be forced to continue receiving the fixed dividend if the company actually experiences a profit and the interest rate rises.

Conclusion

Preferential allotment of securities has both advantages and disadvantages, but it can be very advantageous for a company’s financial stability because it can quickly raise funds.

Methods like preferential allotment of shares and securities are governed by the Companies Act of 2013 and the norms set forth. Shares and convertible securities are both included in the allocation of securities. A shareholder with preferred shares will be treated with greater prominence while the firm is being wound up. 

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