The Companies Act, 20131 permits the companies to raise funds via methods like preferential allotment, right issue, Initial Public Offers, employee Stock Option and Sweat equity shares. Preferential allotment is one of the best methods of raising the capital.
Preferential allotment of shares is a procedure to allot a bulk of fresh shares to a specific group of individuals, investors, or venture companies. It is an issue of shares or convertible securities and can be by listed or unlisted companies. Any company, whether private, public, listed, or unlisted, can go for the process of preferential allotment of securities. The companies choose this method because it is one of the fastest ways to raise the capital and increase the shares of the firm. A person holding preferential shares has the right to be paid before the common shareholders at the time of winding up of the company. The issue is made at a pre-determined price. A company issues such shares in favour of those investors and venture capitalists who wish to gain a higher stake in the firm and can subsequently add value to the company. It can also be a chance for those shareholders who were not able to purchase the shares at the time of Initial Public Offer. It can prove to be a win-win situation for the company as well as shareholders. It is because the company will be able to raise a large amount of capital and increase the flow of money in the firm and the investors or the shareholders shall get a larger share in the company.
The provisions that govern the preferential allotment of shares must be understood to prevent any misuse or abuse of the privilege.
- Section 62 of the Companies Act, 2013 (Section 81 of Companies Act, 1956)
The provision deals with further issue of the share capital. The provision prescribe certain categories of people that the companies must approach for the further raise of capital: persons, who, at the date of offer, hold equity shares of the company by making an offer via notice specifying the number of offered share, the time limit not exceeding thirty days, a right to renounce the shares offered in favour of any person and if the person does not accept, then the firm can dispose of the shares, to employees under Employees Stock Option or to any group of persons authorised by a special resolution and are not included in the above mentioned categories. The notice to such people must be sent by registered post or speed post or by any electronic mode. The section does not extend to debentures or loans from any company or government or financial institution.
In the case of Mrs Proddaturi Malathi vs Srp Logistice Pvt Ltd & Ors2, the appellant challenged the allotment of shares by the respondent in violation of Section 62 of the Companies Act, 2013 as being prejudicial and discriminatory towards the appellant. The Supreme Court held that the provision of Section 62 of the act is applicable to private companies also. The companies can increase their capital by a further issue to existing shareholders. Thus, the allottees must get proper time and chance to renounce the shares.
- Section 42 of the Companies Act, 2013
The section prescribes the offer or invitation for subscription of securities on private placement. It states that the offer shall be made to the number of persons not exceeding fifty, excluding the provisions for employees under Employee Stock Option. For this section, private placement means any offer of securities or such invitation to subscribe the securities to a select group of persons by a company through the issue of private placement along with the satisfaction of the provisions specified in the provided section. The money under such a rule should be paid through demand draft or bank transfer and not by cash. Such an allotment must be done within sixty days of the receipt of the application money.
In the case of Sahara India Real estate Co vs Securities Exchange Board of India3, the Supreme Court of India held that a private placement to friends, relatives or closed people is valid under the provisions of Section 42, provided that the valid procedure is followed.
- Rule 13 of the Companies (Share Capital and Debentures) Rule, 2014
The rule prescribes the provisions and procedure for issue of shares under Section 62 of the Companies Act, 2013 read with Section 42 of the act4. The shares must be issued after authorization by the board by passing a special resolution in a board meeting. The offer or allotment must be according to the provisions of Section 42. The preferential offer must be to more than two members. The price for the issue on a preferential basis by a listed company need not be done by a registered valuer. the rule also defines Preferential Allotment as an issue of shares or other securities to a selected group of people on a preferential basis but does not include rights issue, public offeror sweat equity shares. The same must be authorized by the articles of association and passed by a special resolution in a board meeting. In addition to the registration of forms, the directors must also attach an explanatory statement stating the information about the issue. The preferential allotment must be made within twelve months of passing the resolution. The price of shares must be mentioned and expressly stated in the offer or application made to the allottees. The shares and securities also include convertible instruments. The company's offer must also include a clause stating the price of such conversion.
In the case of ABN Housing Private Limited v Unknown5, the Madras High Court held that the directors of the company must issue convertible instruments in accordance with Rule 13 of the companies (share capital and debentures) rules, 2014 and should be mutually agreed with the transferors.
Advantages of Preferential Allotment
Preferential Allotment of shares is beneficial for the company in many ways. The following are the advantages of Preferential Allotments:
- The first advantage is that there shall be no charge on the assets. Under Preferential allotment, shares and convertible securities are offered. The shares do not create a charge on the assets unlike debentures. Moreover, it is not a requisite for preferential allotment to keep the assets in risk. Thus, it is beneficial for both the companies and existing shareholders.
- The next advantage is an additional benefit to the investors and shareholders. Preferential allotment is a way to deal in convertible securities. If the price of shares increases, the investors and shareholders can convert their convertible securities into shares and earn dividends and extra profits. The dividends and profits are more than the predetermined and fixed interest on the securities or debentures. It is a great opportunity for all the existing shareholders and investors.
- The next advantage is that there need not be any dilution of power. Preferential Allotment does not involve dilution of power as the shareholders do not receive voting rights. The shareholders or investors are entitled to dividends and interest but do not have voting rights or say in the board meetings. It is a benefit for the company and the directors as they will not be required to dilute their powers and share with other shareholders.
- The last advantage is that preferential allotments improve the borrowing capacity of the firm. It reduces the debt-to-equity ratio because it helps them to create a space for non-convertible debentures and loans.
Disadvantages of Preferential Allotment
Every blessing is attached with a curse, likewise, there are both advantages and disadvantages of the concept of preferential allotment. It is also essential to apprehend and understand the limitations of the process:
- Harm to the reputation of the firm: If a company does not pay a
fixed amount of dividend or dividend every year, this might not
invite legal penalties, but this can harm the reputation of a
company. First things first, an investor will not invest in a firm
or in a security that will not yield any gain in future. For
instance, Firm A earns profits and pay dividends every year to its
shareholders and Firm B does not give dividend every year, then an
investor will invest in Firm A to yield gains.
Moreover, it can also affect the reputation of the firm while borrowing the money. It is because lenders will only provide funds if they are satisfied that the company shall pay back the entire amount.
- Lack of voting rights of the investors: An investor delving the funds under preferential allotments shall not receive the same level of voting rights or ownership as a common shareholder. It can also prevent them from investing their savings in such a scheme. Thus, it can provide a benefit of raising a large amount of funds for the operations of the company but may not provide simultaneous benefits to the shareholders.
The Companies Act, 2013 and the rules provided govern the methods like preferential allotment of shares and securities. The allotment of securities includes convertible securities and shares also. It is one of the fastest ways to raise capital for the operations of the business. A person holding preferential shares will be given more importance at the time of winding up of the company. The issue is made at a predetermined price. There are certain provisions of the Companies Act, 2013 and certain rules provided under Companies (Share Capital and Debentures) Rules, 2014 and Companies (Prospectus and Allotment of Securities) Rules, 2014. But it can also lead to power in only few hands because only some people shall buy the shares and keep the decision-making power in the hands of the majority shareholders. There are practical scenarios where the companies and the majority shareholders took the advantage of the preferential allotment of shares. Thus, preferential allotment of shares is an efficient and effective way so that the directors can raise money.
1. Act no. 18 of 2013.
2. Cr. Appeal No. 239 of 2017
3. C.A. No. 9813 of 2011
4. The, supra Note 1 at 6
5. C.P. Nos. 525 to 531 of 2015
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.