What Is an Allotment?
The term allotment refers to the systematic distribution or assignment of resources in a business to various entities over time. Allotment generally means the distribution of equity, particularly shares granted to a participating underwriting firm during an initial public offering (IPO).
There are several types of allotment that arise when new shares are issued and allocated to either new or existing shareholders. Companies allot shares and other resources when demand is much stronger than the available supply.
Key Takeaways
- An allotment is the systematic distribution of business resources across different entities and over time.
- It generally refers to the allocation of shares granted to a participating underwriting firm during an initial public offering.
- Allotments are commonly executed when demand is strong and exceeds demand.
- Companies can also execute allotments through stock splits, employee stock options, and rights offerings.
- The main reason that a company issues new shares for allotment is to raise money to finance business operations.
Understanding Allotments
In business, allotment describes the systematic distribution of resources across different entities and over time. In finance, the term typically relates to the allocation of shares during a public share issuance. When a private company wants to raise capital for any reason (to fund operations, make a large purchase, or acquire a rival), it may decide to issue shares by going public. Two or more financial institutions usually underwrite a public offering. Each underwriter receives a specific number of shares to sell.
The allotment process can get somewhat complicated during an IPO, even for individual investors. That’s because stock markets are incredibly efficient mechanisms for matching prices and quantities, but the demand must be estimated before an IPO takes place. Investors must express interest in how many shares they would like to purchase at a specific price before the IPO.
If demand is too high, the actual allotment of shares received by an investor may be lower than the amount requested. If demand is too low, which means the IPO is undersubscribed, then the investor may be able to get the desired allotment at a lower price.
On the other hand, low demand often leads to the share price falling after the IPO takes place. This means that the allotment is oversubscribed.
It’s a good idea for first-time IPO investors to start small because allotment can often be a tricky process.
Other Forms of Allotment
An IPO is not the only case of share allocation. Allotment can also occur when a company’s directors earmark new shares to predetermined shareholders. These are investors who have either applied for new shares or earned them by owning existing shares. For example, the company allocates shares proportionately based on existing ownership in a stock split.
Companies allot shares to their employees through employee stock options (ESOs). This is a form of compensation that companies offer to attract new and keep existing employees in addition to salaries and wages. ESOs incentivize employees to perform better by increasing the number of shares without diluting ownership.
Rights offerings or rights issues allocate shares to investors who wish to purchase more rather than doing so automatically. Thus, it gives investors the right but not the obligation to purchase additional shares in the company. Some companies may elect to do a rights issue to the shareholders of a company they want to acquire. This allows the acquiring company to raise capital by giving investors in the target firm an ownership stake in the newly formed company.
Any remaining shares go to other firms that win the bid for the right to sell them.
Reasons for Raising Shares
The number one reason a company issues new shares for allotment is to raise money to finance business operations. An IPO is also used to raise capital. In fact, there are very few other reasons why a company would issue and allocate new shares.
New shares can be issued to repay a public company’s short- or long-term debt. Paying down debt helps a company with interest payments. It also changes critical financial ratios such as the debt-to-equity ratio and debt-to-asset ratio. There are times when a company may want to issue new shares, even if there is little or no debt. When companies face situations where current growth is outpacing sustainable growth, they may issue new shares to fund the continuation of organic growth.
Company directors may issue new shares to fund the acquisition or takeover of another business. In the case of a takeover, new shares can be allotted to existing shareholders of the acquired company, efficiently exchanging their shares for equity in the acquiring company.
As a form of reward to existing shareholders and stakeholders, companies issue and allot new shares. A scrip dividend, for example, is a dividend that gives equity holders some new shares proportional to the value of what they would have received had the dividend been cash.
Overallotment Options
There are options for underwriters where additional shares can be sold in an IPO or follow-on offering. This is called an overallotment or greenshoe option.
In an overallotment, underwriters have the option to issue more than 15% shares than the company originally intended to do. This option doesn’t have to be exercised the day of the overallotment. Instead, companies can take as long as 30 days to do so. Companies do this when shares trade higher than the offering price and when demand is really high.
Overallotments allow companies to stabilize the price of their shares on the stock market while ensuring it floats below the offering price. If the price increases above this threshold, underwriters can purchase the additional shares at the offering price. Doing so ensures they don’t have to deal with losses. But if the price falls below the offering price, underwriters can decrease the supply by purchasing some of the shares. This may push the price up.
What Is an IPO Greenshoe?
A greenshoe is an overallotment option that occurs during an IPO. A greenshoe or overallotment agreement allows underwriters to sell additional shares than the company originally intended. This generally occurs when investor demand is particularly high—higher than originally expected.
Greenshoe options allow underwriters to flatten out any fluctuations and stabilize prices. Underwriters are able to sell as much as 15% more shares up to 30 days after the initial public offering in case demand increases.
What Is Share Oversubscription and Undersubscription?
An oversubscription takes place when demand for shares is higher than anticipated. In this kind of scenario, prices can rise significantly. Investors end up receiving a lower amount of shares for a higher price.
An undersubscription occurs when demand for shares is lower than a company expects. This situation causes the stock price to drop. This means that an investor gets more shares than they expected at a lower price.
How Does an IPO Determine the Allotment of Shares?
Underwriters must determine how much they expect to sell before an initial public offering takes place by estimating demand. Once this is determined, they are granted a certain number of shares, which they must sell to the public in the IPO. Prices are determined by gauging demand from the market—higher demand means the company can command a higher price for the IPO. Lower demand, on the other hand, leads to a lower IPO price per share.