Advantages and Disadvantages of Preferential Allotment

A shortage of finances is inevitable while running a business that compels an entrepreneur to explore fundraising methods. The Company Act 2013 prescribes various ways to raise the company’s capital, which entail the right issue, sweat equity shares, employee stock ownership plan, IPOs, and preferential allotment. Amongst all the stated methods, preferential allotment seems to be the best source of fundraising for the companies listed on the stock exchange. The preferential allotment is considered as a hybrid financing instrument since it has attributes of both debt and equity. Prior to raising capital from this mode, it is essential to perceive the advantages and disadvantages of preferential allotment.

An Insight of Preferential Allotment

The preferential allotment is the process of allotting shares to a selected group of individuals or companies based on preferences. All the listed companies gain the authority to allot their shares on a preferential basis. For the issue of preference shares, the listed companies need to comply with the stringent provisions of SEBI. However, in the case of unlisted companies, the norms of Companies Act, 2013, are applicable.

The concept of preferential allotment forms a win-win situation for the company and shareholders as it helps the company to raises its funds while the shareholders get the dividend according to their priority.

Moreover, the company gets the power to meet its financial requirements by raising funds from the general public. On the downside, the procedure of share allotment is a time-consuming and complex method, but by shortlisting shareholders beforehand, the companies can save much time.

Regulatory Framework that governs Preferential Allotment

Following are the regulatory frameworks which monitor the process of preferential allotment:

• Section 62 (allocation of shares) and Section 42 (allotment of securities) of the Companies Act 2013 regulates the allotment of private shares. A company that seeks to issue the shares must adhere to both the Sections; however, for the issue of securities, the company just needs to comply with the provisions of Section 42 only. 
• Provisions of SEBI (ICDR) Regulations, 2009.

Advantages and Disadvantages of Preferential Allotment

By the issue of share on preferential bases, a company can avail several benefits, but it also has some drawbacks. So let’s comprehend the advantages and disadvantages of preferential allotment one by one:

• No charges on assets- When a company takes a loan from the bank, it is mandatory to deposit collateral security. Besides, there is no such requisite in the allotment of preferential shares; the company raises the needed amount without putting its assets on risk.  Further, no charges are levied on the company’s assets, unlike in the case of debentures.
• An additional benefit to investors- Preferential allotment facilitates investors to trade in convertible shares for a fixed no. of common stocks that can be lucrative if the value of common shares rises. Thus, the investors gain additional dividends, which are more than the fixed-rate if the company achieves certain predetermined profit targets. It also provides an opportunity to buy shares in bulk to those shareholders who can’t afford to purchase shares from the market.
• No dilution of power– Issuance of preference share does not dilute the powers of existing equity shareholders as the company does not give any voting rights to the preference shareholders. In simple terms, the preference shareholders invest their capital with a fixed dividend percentage, yet they do not get control rights.
• Reform the company’s borrowing capacity– Once allotted; the preference shares become the part of the company’s net worth, which reduces the debt to equity ratio.

Disadvantages of Preferential Allotment

Every blessing is accompanied by a disguised curse; likewise, there are both advantages and disadvantages of preferential allotment. Now that we have apprehended the benefits, it’s time to look at the limitations:

•  Defames the image of the company– Not making dividend payments may not be harmful for the company in legal terms, but it can affect its image in the eyes of investors. When the company applies for any other finance, the lender shall have this as a major concern.
• Lack of voting rights- The preference shareholders do not relish the same voting rights which the company provides to the common shareholders.
• Impact credit worthiness- Preferential allotment reduces the creditworthiness of a company as the preference shareholders get the right over the company’s personal assets.

Preconditions on Preferential Allotment

After going through the advantages and disadvantages of preferential allotment, you must be eager to issue the shares. Besides, there are some conditions which you must fulfil before the issue of preferential allotment:

• Firstly, the company must acquire approval from shareholders through the Extraordinary General Meeting, Postal Ballot, or AGM.
• Obtain the application letter from the proposed shareholders prior to the Board Meeting.
• Get the issue authorized under the Article of Association.
• Make a list of people with the maximum limit of 200 to whom you will propose to offer preference shares in a financial year for each type of security.
• Prepare the offer letter in form PAS-4 and open a separate bank account that a shareholder can utilize to subscribe to its share. The money in the bank shall only be used for the allotment or return.
• Set a value for the offer that must not be less than INR 20,000 per person.
• The company cannot issue the preference shares to a person who has sold its equity shares during the 6 months before the relevant date. Relevant date implies to 30 days before the date of the EGM of the company.

Conclusion

There are both advantages and disadvantages of preferential allotment, yet one can determine that it the best source of raising capital for a company.

If you also strive to issue the preference shares of your company, take the guidance of a legal consultancy like Swarit Advisors. Our team can help you prepare the offer letter, valuation report, and help you file several forms to the regulatory authority of SEBI.