Preferential Allotment: Meaning and Process

Preferential allotment is a corporate funding mechanism where companies issue shares to selected investors at negotiated terms. This method enables swift capital raising, often bringing strategic partners on board, while bypassing the extensive procedures of public offerings.

Preferential allotment is a pivotal tool for companies seeking targeted capital infusion. Companies choose preferential allotment to issue shares to a select group of investors such as venture capitalists and strategic partners. This move quickly secured the necessary funds while aligning with partners who could offer industry expertise and market access.

In India, Reliance Industries Limited is a notable example of a company utilizing preferential allotment. They have employed this strategy to attract strategic investments and bolster their business ventures. In the USA, Tesla Inc. has also used preferential allotment, notably when issuing shares to specific strategic investors to secure funding for their ambitious projects. 

These companies leverage preferential allotment to access capital and strategic partnerships, crucial for their expansive business models. Let’s understand Preferential allotment which is an important financial concept. 

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Table of Content

• What is Preferential Allotment?
• Legal Framework and Regulations
• Process of Preferential Allotment
• Advantages of Preferential Allotment
• Disadvantages of Preferential Allotment
• Difference Between Right Issue and Preferential Allotment

What is Preferential Allotment?

Preferential allotment is a process where a company issues shares or convertible securities to a select group of investors, not through a public offering. This method is typically used to raise capital and can include shares offered to existing shareholders, venture capitalists, or strategic partners. Preferential allotment is governed by specific regulations and often aims at bringing in high-value investors or restructuring debt.

Legal Framework and Regulations

Companies Act 2013:

Section 42 (Allotment of Securities on Private Placement Basis): Sets out procedures for private placements, which include preferential allotments.

Section 62(1)(c): Details the process for preferential allotment of shares, including the requirement for a special resolution.

SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018:

Chapter V (Preferential Issue): Specifies regulations for preferential issues by listed companies, including pricing, disclosures, lock-in requirements, and eligibility criteria for allottees.

Listing Obligations and Disclosure Requirements (LODR) by SEBI:

This includes various clauses that listed companies must comply with when making preferential allotments, ensuring continuous disclosure and transparency.

Foreign Exchange Management Act (FEMA), 1999:

FEMA regulations and guidelines issued by the Reserve Bank of India govern the preferential allotment of shares to non-residents or foreign investors, including pricing guidelines and reporting requirements.

Income Tax Act, 1961:

Certain sections may be applicable regarding taxation implications of preferential allotments, especially in the context of issue pricing and valuation

These sections and regulations ensure that preferential allotments are conducted in a manner that is transparent, equitable, and following legal requirements, safeguarding the interests of investors and the integrity of the capital markets.

Process of Preferential Allotment

Board Meeting: The company's board of directors convenes to discuss and propose the issuance of shares through preferential allotment.

Special Resolution: The proposal is then put to a shareholder vote, requiring approval through a special resolution in an Extraordinary General Meeting (EGM) or Annual General Meeting (AGM).

Pricing: The issue price is determined as per regulatory guidelines, often based on the average of high and low stock prices in the preceding weeks.

SEBI and Stock Exchange Compliance: Listed companies must comply with SEBI regulations and file necessary documents with the stock exchange.

Allotment: Once regulatory approvals are secured, shares are allotted to the identified investors.

Reporting: Post-allotment, the company must report the details to regulatory authorities and ensure compliance with any post-allotment regulatory requirements.

Advantages of Preferential Allotment

Rapid Fundraising

Preferential allotment enables companies to raise funds more quickly than public offerings. It bypasses the lengthy processes of IPOs, such as roadshows and regulatory compliances, allowing for quicker capital infusion to meet urgent financial needs or seize growth opportunities.

Cost-Effectiveness

This method is more cost-effective due to lower issuance costs. It avoids significant expenses associated with public offerings, like underwriting fees, extensive marketing campaigns, and various regulatory filing fees, thereby reducing the overall cost of capital.

Pricing Flexibility

Companies have a degree of flexibility in setting the issue price for shares, within the confines of regulatory guidelines. This can be particularly advantageous in volatile market conditions, allowing companies to price shares in a way that balances investor appeal with fundraising objectives.

Attracting Strategic Investors

Preferential allotment provides an opportunity to selectively bring in strategic investors, such as venture capitalists, who can offer not just capital but also valuable industry insights, management expertise, and business connections.

Minimized Equity Dilution

Compared to public offerings, preferential allotment often leads to less equity dilution, especially if shares are allotted at a premium. This is beneficial for existing shareholders as it minimizes the reduction in their ownership percentage and voting power.

Debt Restructuring

It is an effective tool for companies aiming to convert debt into equity. This helps in restructuring the balance sheet, improving financial ratios like debt-to-equity, and potentially easing cash flow pressures.

Disadvantages of Preferential Allotment

Regulatory Scrutiny and Compliance

Preferential allotments are subject to stringent regulatory norms and require compliance with various provisions of the Companies Act and SEBI guidelines. Navigating these regulations can be complex and time-consuming, adding to administrative burdens.

Impact on Shareholder Value

If the allotment is done at a price lower than the market price, it can lead to a dilution of the value for existing shareholders. This dilution might not be well-received and could affect investor confidence.

Market Perception

The market might perceive preferential allotment as a sign that the company is unable to raise funds through more traditional means, which could negatively impact the company's reputation and stock price.

Limited Investor Base

Since the allotment is made to a selected group of investors, unlike an IPO or FPO which is open to the public, the company might miss out on a broader investor base and greater market exposure.

Risk of Overpricing or Underpricing

Determining the right issue price can be challenging. Overpricing might lead to under-subscription, while underpricing could result in leaving money on the table, and not realizing the full potential value.

Potential for Conflict of Interest

Preferential allotment to insiders or related parties can lead to conflicts of interest and allegations of unfair practices, especially if not conducted at arm's length or if the terms are not in the best interest of all shareholders.

Difference Between Right Issue and Preferential Allotment