What is Allotment?
The term allotment, in business, refers to the structured and systematic distribution of the business’ resources. Commonly, the term allotment is used in the context of equity distribution in finance.
A company that offers its shares to the public uses the process of allotment to determine the amount of stock offered to different entities. The entities include the underwriting firm that’s been chosen for the initial public offering (IPO) of the company and others that are given the right to sell IPO shares.
- Allotment refers to the structured and systematic distribution of business resources.
- A company that offers its shares to the public uses the process of allotment to determine the amount of stock offered to different entities.
- Companies launch IPOs as a means of distributing stock to potential investors, but there are other methods of raising equity capital as well. They include stock splits, rights issue, employee stock options, etc.
Allotment in an IPO
Companies launch IPOs as a means of distributing stock to potential investors. Typically, companies decide to go public when they need to raise capital for debt financing, growth financing, etc. The process of a public share issuance involves financial institutions called underwriters. Usually, companies opt for two or more underwriters. Each of the entities is given the responsibility to sell a predetermined number of the company’s shares directly to the public.
The allotment must be determined by the participating firms before the actual IPO takes place. It means that the participants must estimate demand beforehand. Although stock markets provide an efficient mechanism for determining prices of shares and the corresponding quantity demanded, it is impossible to accurately predict the same. It means that the allotment process can get complicated.
If the actual demand for the company stock turns out to be higher than anticipated, it is known as oversubscription of the issue. It means that the number of shares that is allotted to each individual investor is lower than the amount requested or desired by them. The oversubscription causes a spike in the prices of the shares shortly after the IPO begins.
If the actual demand for the stock is lower than what is predicted by the company, it means that the IPO is undersubscribed. It leads to a fall in the share price, which means that not only does the investor get their desired allotment, but they also need to pay a lower price than was previously announced.
Other Forms of Preferential Allotment
1. Stock Split
Share allocation can occur in multiple other ways as well. One of the ways is known as a stock split. It is usually done when an existing public company needs to raise more capital. Under the stock split system, the directors of a company may decide to earmark stock to all or a limited number of existing shareholders.
They may be shareholders who previously applied for new shares or are existing shareholders of the company. The company may then use pro-rata allotment, or a proportionality principle, to distribute more shares among existing shareholders.
2. Rights Issue
A company may also opt for a right’s issue. In a rights issue, rather than allocating shares automatically, the company gives existing shareholders the option to buy new shares. For example, a company may announce that an investor may apply to purchase one new share for every ten shares held by the investors.
A company may also raise equity capital in order to fund a takeover or an acquisition of another company. In such a case, rather than raising capital on the stock market, the company may allot the shares to the existing shareholders of the company that is being acquired. It is an effective method for the investor to trade their old shares for equity ownership in the acquiring company.
3. Employee Stock Options (ESOPs)
Companies may also use systems such as employee stock options (ESOPs). Under ESOPs, companies may allot shares worth part of the employee salary to their employees, rather than paying the full salary. It is an effective method of boosting employee ownership in firms and creating incentives for better performance.
The above allotment types are widely considered a good way to rewarding existing shareholders. They also enable companies to issue more shares without necessarily diluting share ownership. In some cases, dilution may be an effective way of overcoming the potentially adverse influence of outside forces or extremely large shareholders on the company.
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