Preferential allotment and its effect on investors

Team Paul Asset | November 21, 2015| 7 Comments

What is Preferential Allotment?

Preferential allotment is the process by which allotment of shares is done on a preferential basis to a select group of investors.Now let us understand about it in details. A company plans to raise funds for its future expansion activities and reducing debt. But issuing securities to the public at large can be very time-consuming and complicated process. So, the company may decide to issue a wholesale quantity of shares to a group of people or companies those are interested. This makes a lot of paper work easier as well as is a lucid way to raise some funds.

Why few companies prefer preferential allotment ?

The principal purpose is to enlarge its share capital. They have three options to do the same:

  1. New issue of shares to present shareholders.
  2. Making an open offer.
  3. Bulk allotment of shares to a group of individuals or companies.

The rationale behind preferential allotment is to provide a way to enable the equity participation of those who can be shareholders, but for whom it may be exceedingly costly or unfeasible to buy large chunks of shares from the market.

Whom to allot?

In general, preferential allotment are given to people who desire to take a strategic stake in the company. For example, venture capitalists, high net worth existing shareholders, promoters who desire to increase their stake in the company, financial organizations etc.

Also note, preferential shares do not have voting rights. Companies may pay dividend only if they earn a profit. In the cumulative option, if the company does not pay dividend within one year, the holder has the right to the get the payment the subsequent year. In the worst case scenario of liquidation, holders of preference shares are put beneath the NCD holders in terms of claim on assets.

Effect on EPS for preferential allotment :

A convertible preferred stock can be exchanged for common stock at a prearranged ratio. This exchange is generally happens only if the price of the common shares increases after the issuance of preferred stock.

Convertible preferred stock is dilutive as conversion increases the number of common shares, reducing the ownership level and EPS of each.

Effect on retail investors:

Not every investor can get Preferential allotment . The 10 lac minimum investment threshold and the fact that these shares are typically issued through private placements, makes it a distinct investment option for the high net worth individuals.

Preference shares appeal to HNIs as they give tax-free returns. Preference shares are riskier than bonds, but when compared with equity stocks, the risk is relatively less. This is for the reason that when a company goes bankrupt, bond holders have the primary right on the assets. It is only after the debenture and other debt instrument holders are paid, that shareholders get payment of their dues.

Retail investors are advised not to get lured by preferential allotment. This option is only accessible for high net worth individuals. The number of outstanding shares  increase after preferential allotment thus reducing the EPS (Earning per share) which in turn increase P.E ratio that has negative impact on existing shareholders. However, have a close look whether preferential shares are allotted to any well-informed veteran investors. In that case, it has positive impact on stock price.

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7 Replies to “Preferential allotment and its effect on investors”

  1. What if promoters buy preferential shares? Isnt it beneficial for retail investors too? As promoters themselves are infusing capital at the current trading rate and in future, they might expect great appreciation in share price?

    1. Yes, promoters buying preferential shares around the current market rate is positive for shareholders. (Open market purchase by Promoters is considered more positive)

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