What Is the Exchange Ratio?
Let me explain the exchange ratio directly to you: it's the relative number of new shares that existing shareholders of an acquired or merging company will receive. Once the old shares are turned in, this ratio ensures you get the same relative value in the shares of the new merged entity.
Understanding the Exchange Ratio
You need to know that the exchange ratio is set up to provide you, as a shareholder, with stock in the acquiring company that holds the same relative value as what you had in the target company. Remember, the target company's share price usually gets a boost from a 'takeover premium'—that's the extra amount the acquirer pays to gain 100% control and all outstanding shares.
This relative value doesn't mean you'll get the exact same number of shares or the same dollar amount based on current prices. Instead, we consider the intrinsic value of the shares and the underlying value of the company when determining this ratio.
Calculating the Exchange Ratio
The exchange ratio comes into play only in deals paid with stock or a stock-cash mix, not pure cash transactions. The basic calculation is straightforward: divide the target share price by the acquirer share price.
The target share price here is the offered price. Since share prices can fluctuate between the initial agreement and closing, the ratio is often structured as either fixed or floating. With a fixed exchange ratio, it stays the same until closing—you know the number of shares issued, but the deal's value might vary. Acquirers like this because it locks in the percentage of control.
On the other hand, a floating exchange ratio adjusts so the target receives a fixed value regardless of price changes. Here, the number of shares is unknown, but the deal value is certain. Targets prefer this to ensure they get the exact value agreed upon.
Example of the Exchange Ratio
Consider this scenario: a buyer offers two shares of their company for each one share of the seller's company. Before the deal announcement, the buyer's shares trade at $10, and the seller's at $15. With a 2-to-1 ratio, the buyer is effectively paying $20 for a share worth $15 on the market.
Fixed ratios often include caps and floors to handle extreme stock price swings—these protect both sides from receiving or giving far less or more than expected. After announcement, a valuation gap usually appears between the companies' shares, accounting for time value of money and risks like government blocks, shareholder rejection, or market shifts.
Investors can capitalize on this gap through merger arbitrage, especially if they believe the deal will close. Using the example, if buyer's shares remain at $10 and seller's rise to $18, there's a $2 gap. You could buy one seller share at $18 and short two buyer shares at $20 total. If the deal closes, you'd exchange for two buyer shares, close the short, and net $2 after your $18 outlay.
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