Definition of allotment, rationale for increasing stakes, initial public offerings

What Is an Allotment?

An allotment refers to the strategic distribution or assignment of resources within a business to different entities gradually. Specifically, in finance, allotment involves distributing equity, especially shares allocated to a participating underwriting firm during an initial public offering (IPO).

Various types of allotment occur when new shares are issued and distributed to either new or existing shareholders. Companies opt for allotments when demand overwhelmingly surpasses the available supply.

Key Takeaways

• An allotment involves the systematic allocation of business resources across different entities over time.
• It usually entails the distribution of shares granted to a participating underwriting firm during an IPO.
• Allotments are commonly carried out when demand exceeds supply.
• Companies execute allotments through stock splits, employee stock options, and rights offerings.
• The primary reason for a company to issue new shares for allotment is to raise capital for business operations.

Understanding Allotments

In business, allotment entails the systematic distribution of resources among different entities over time, while in finance, it often relates to the allocation of shares in a public share issuance. When a private company aims to raise capital, it may decide to issue shares through going public. In a public offering, multiple financial institutions underwrite the process and receive a specific number of shares for sale.

Throughout an IPO, the allotment process can become complex, particularly for individual investors. Stock markets efficiently match prices and quantities, but estimating demand is crucial before an IPO. Investors must indicate the number of shares they desire to purchase at a specific price prior to the IPO.

In cases of high demand, investors might receive fewer shares than requested, while an undersubscribed IPO could allow investors to obtain the desired allotment at a lower price. Low demand often results in oversubscribed allotments, leading to a decrease in share price post-IPO.

For IPO newcomers, starting with smaller investments is advisable due to the intricacies of the allotment process.

Other Forms of Allotment

Allotment is not exclusive to IPOs but can also occur when a company’s directors assign new shares to predetermined shareholders, who have either applied for new shares or earned them through existing ownership. Companies may allocate shares based on existing ownership during a stock split, for instance.

Through employee stock options (ESOs), companies allocate shares to employees, providing additional compensation beyond salaries. ESOs motivate employees by increasing shares without diluting ownership.

Rights offerings give investors the option to purchase more shares rather than automatic allocation. This strategy allows investors the choice but not the obligation to buy additional company shares. Some companies opt for rights offerings to target firms’ shareholders during acquisitions to raise capital and offer ownership stakes in the new entity.

Remaining shares are typically awarded to winning bidding firms for sale.

Reasons for Raising Shares

The primary motive behind issuing new shares for allotment is to fund business operations. Companies also utilize IPOs to raise capital, with few other reasons justifying the issuance of new shares.

New shares may be issued to pay off a public enterprise’s short- or long-term debts, assisting with interest payments and altering key financial ratios. Companies may opt for new share issuance even in low-debt scenarios when current growth surpasses sustainable growth levels, necessitating funds for organic expansion.

Issuing new shares to finance business acquisitions or takeovers is common among company directors. In acquisitions, new shares can be allocated to existing shareholders of the acquired company, enabling the exchange of shares efficiently for equity in the acquiring company.

Companies also issue new shares as a form of reward to current shareholders and stakeholders, such as through a scrip dividend, providing equity holders with new shares in proportion to a cash dividend’s value.

Overallotment Options

Underwriters have the option to sell additional shares beyond the original intent during an IPO or follow-on offering, known as an overallotment or greenshoe option.

With an overallotment, underwriters can issue over 15% more shares than initially planned, with a 30-day window for exercise, typically done when shares trade above the offering price due to high demand.

Overallotments help companies stabilize share prices on the market, ensuring they remain below the offering price threshold. If share prices exceed this threshold, underwriters can buy additional shares at the offering price to avoid losses. Conversely, if prices drop below the offering price, underwriters can reduce supply by purchasing shares, potentially raising prices.

What Is an IPO Greenshoe?

A greenshoe, an overallotment option during an IPO, permits underwriters to sell more shares than originally intended. This is typically exercised when investor demand far surpasses initial expectations.

Greenshoe options enable underwriters to stabilize prices in case of demand fluctuations, allowing for the sale of up to 15% more shares within 30 days post-IPO if demand rises.

What Is Share Oversubscription and Undersubscription?

Oversubscription occurs when share demand exceeds expectations, prompting significant price increases. In this scenario, investors may receive fewer shares at a higher price.

Undersubscription takes place when share demand falls below expectations, leading to stock price drops. Investors might receive more shares than anticipated at a reduced price.

How Does an IPO Determine the Allotment of Shares?

Prior to an initial public offering, underwriters estimate expected sales by gauging demand, receiving a particular share allotment for public offering. Market demand influences pricing, with higher demand allowing for higher IPO prices per share, while lower demand results in reduced prices.