Advantage and Disadvantage of Preferential Allotment | Jordensky

A lack of funds is unavoidable when running a business, forcing an entrepreneur to look into fundraising tactics. The Company Act of 2013 specifies several methods for raising a company's capital, including the Right Issue, Sweat Equity Shares, Employee Stock Ownership Plans (ESOP), IPOs, and Preferential Allotment.

Among all of the strategies mentioned, Issuance of Preference Shares appears to be the best form of funding as it combines elements of Debt and Equity, preferential allotment is regarded as a hybrid financing tool. Prior to obtaining capital through this channel, it is critical to understand the Advantages and Disadvantages of preferential allotment.

What is Preferential Allotment

The technique of allocating shares to a specified set of individuals or corporations based on preferences is known as preferential allocation. All publicly traded corporations gain the authority to allocatetheir shares preferentially. Listed firms must comply with SEBI's rigorous regulations for issuing preference shares. However, the requirements of the Firms Act, 2013, apply to unlisted companies.

The notion of preferential allotment creates a win-win situation for both the company and the shareholders since it allows the companyto raise capital while the shareholders get dividends based on their priority.

Furthermore, the company gains the ability to meet itsfinancial needs by soliciting cash from the general public. On the downside,the practice of share allotment is time-consuming and complex, althoughcorporations can save a lot of time by shortlisting shareholders ahead of time.

Regulatory Framework that governs Preferential Allotment

The regulatory structures that oversee the process ofpreferred allotment are as follows:

• The allocation of private shares is governed by Sections 62 (allocation of shares) and 42 (allotment of securities) of the Companies Act 2013. A company that wants to issue shares must follow both Sections; however, for the issuance of securities, the corporation simply needs to follow Section 42.
• Provisions of SEBI (ICDR) Regulations, 2009.

Advantages of Preferential Allotment

A firm can get various advantages by issuing preferentialshares, but it also has some disadvantages. So, let us examine the benefits anddrawbacks of preferred allotment one by one:

• No Charges / Lien on Company Assets - When a company obtains a bank loan, it is required to deposit collateral security. Furthermore, there is no such requirement in the distribution of preferred shares; the firm raises the required amount without putting its assets at risk. Furthermore, unlike debentures, no charges are imposed on the company's assets.

• An additional advantage for investors- Preferential allotment allows investors to trade in convertible shares for a fixed number of common stocks, which can be profitable if the value of the common stock rises. As a result, if the company meets certain specified profit targets, investors receive additional dividends that are greater than the fixed rate. It also allows stockholders who cannot afford to buy shares on the open market to purchase them in bulk.

• No Dilution for Existing Shareholders - The issuance of preference shares does not diminish the powers of existing equity shareholders because the corporation does not grant preference shareholders voting rights. To put it simply, preference shareholders invest their cash with a fixed dividend % but do not have control rights.

• Increasing Company's Borrowing Capacity- Once issued, preference shares become part of the company's net worth, lowering the debt to equity ratio.

Disadvantages of Preferential Allotment

Every blessing comes with a hidden evil, and preferential allotment has both advantages and disadvantages. Now that we've seen the advantages, let's have a look at the disadvantages

• Defames the Company's Image- While not paying dividends is not illegal, it can have a negative impact on the company's image in the eyes of investors. When the company seeks for more financing, the lender will take this into consideration
• ‍Lack of Voting Rights- Voting rights are not granted to preference shareholders in the same way that they are granted to regular shareholders
• Claim on Assets - Preferential shareholders actually have claim to the company’s assets, which becomes undesirable on the part of the company.

Preconditions for Issuance of Preferential Allotment

You must be eager to issue the shares after considering the advantages and disadvantages of preferential allotment. Furthermore, there are additional conditions that must be met prior to the provision of preferredallotment:

• First, the corporation must obtain shareholder approval via the Extraordinary General Meeting, Postal Ballot, or AGM.
• Prior to the Board Meeting, obtain the application letter from the proposed shareholders.
• Obtain authorization for the issue under the Articles of Association.
• Make a list of people to whom you will suggest offering preference shares in a fiscal year for each form of investment.
• Prepare the offer letter in PAS-4 format and set up a separate bank account where a shareholder can subscribe to its share. The funds in the bank are only to be utilized for allotment or return.
• Set a price for the offer that is at least INR 20,000 per individual.
• The corporation cannot issue preference shares to someone who has sold equity interests in the six months preceding the relevant date. The relevant date is 30 days before the company's annual general meeting.

Conclusion

Although preferential allotment has both advantages anddownsides, it can be determined that it is the best source of financing for acompany.

If you want to issue preference shares for your company,seek the advice of a legal firm like Jordensky. Our team can assist you inpreparing accounting, taxes, MIS, and CFO services for new and growing firms.

When you work with Jordensky, you have a team of financespecialists who take care of the financial details so you can focus on yourbusiness.