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.

Preferential allotment also plays a strategic role during financial distress or expansion by enabling quick capital infusion without significant dilution of control. Furthermore, the company gains the ability to meet its financial needs by soliciting cash from the general public. On the down side, the practice of share allotment is time-consuming and complex, although corporations can save a lot of time by shortlisting shareholders ahead of time. Therefore, understanding the advantages and disadvantages of preferential allotment becomes crucial for companies to make informed, compliant decisions.

Regulatory Framework that governs Preferential Allotment

The regulatory structures that oversee the process of preferred 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.
• Failure to comply with these provisions may lead to strict penalties, including monetary fines, legal action, and disqualification of company directors, reinforcing the need for accurate and timely adherence.
• Recent amendments in the regulatory framework, particularly by SEBI, have introduced stricter disclosure requirements and shorter compliance timelines, aimed at promoting greater transparency and accountability in the preferential allotment process.

Advantages of Preferential Allotment

A firm can get various advantages by issuing preferential shares, but it also has some disadvantages. So, let us examine the benefits and drawbacks 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.

• Fast Fundraising – Preferential allotment enables quicker access to capital, which is especially critical in competitive or time-sensitive business environments.

• Strategic Partnerships – It provides an opportunity to onboard strategic investors, advisors, or partners on favorable terms, supporting long-term growth.

• Flexible Structuring – Terms can be customized in terms of dividend rates, redemption periods, and conversion options, aligning with the company’s financial strategy.

• Boosts Investor Confidence –When structured transparently and backed by credible stakeholders, it enhances investor trust and market reputation.

• Debt Restructuring Option –It can also serve as a tool for refinancing or restructuring existing debtunder improved conditions.

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.‍
• Limited Market Appeal – Non-convertible preference shares often face low investor interest, especially during volatile market conditions, limiting fundraising options.‍
• Governance Concerns – Excessive reliance on preferential allotment may raise questions around governance practices and potentially weaken board independence.‍
• Control Dilution Risk – Convertible preference shares can unexpectedly dilute promoter or major shareholder control if early conversion is triggered by market fluctuations.‍
• Regulatory Complexity – The process involves intricate compliance obligations that may lead to increased legal and administrative expenses for 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 preferred allotment:

• 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.

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When Should Companies Choose Preferential Allotment?

• In urgent need of capital – Preferential allotment helps companies raise funds quickly without lengthy procedures.
• Want to avoid dilution of control – It allows promoters to raise capital without giving away voting rights.
• Looking to bring in strategic investors – Companies can onboard investors who offer expertise and business connections.
• Preparing for future IPO or acquisition – Strengthening the capital base improves valuation ahead of public listing or sale.
• Preferential allotment as a bridge funding tool before venture capital rounds – It offers temporary funding support until larger VC investments are secured.
• Ideal for companies in sectors like SaaS, fintech, and manufacturing where asset-light models require fast capital – These sectors benefit from quick, collateral-free funding options.

Preferential Allotment vs Other Fundraising Methods

 Preferential allotment stands out among fundraising methods for its speed, flexibility, and targeted investor approach. Unlike public offerings, which are time-consuming and heavily regulated, or bank loans that require collateral and increase debt, preferential allotment enables companies to secure capital without diluting control or overburdening their balance sheets. It also offers more strategic value compared to rights issues, as companies can onboard select investors who bring expertise and long-term partnership potential. This makes it a compelling choice for firms seeking efficient capital infusion with minimal regulatory friction.

Conclusion

Although preferential allotment has both advantages and downsides, it can be determined that it is the best source of financing for a company. The preferential allotment of shares is a strategic tool that enables companies to raise capital efficiently while managing ownership structure. However, companies must carefully balance the speed of raising capital with there gulatory rigor involved to ensure long-term sustainability and compliance.

If you want to issue preference shares for your company, seek the advice of a legal firm like Jordensky. Our team can assist you in preparing accounting, taxes, MIS, and CFO services for new and growing firms.
Considering the advantages and disadvantages of preferential allotment, it is always wise to consult with trusted financial and legal advisors to make informed and strategic funding decisions.

When you work with Jordensky, you have a team of finance specialists who take care of the financial details so you can focus on your business.