What is the Exchange Ratio?
The exchange ratio measures the number of new shares that an acquiring company needs to issue for each share of the target company in a mergers and acquisitions (M&A) deal. When an M&A deal is partially or fully financed through equity (known as a ‘share swap’), the acquiring company pays for the target company’s shares in the form of its own shares.
The exchange ratio helps in understanding the mechanism of such deals. Simply put, if the acquiring company is offering 2 shares of its own stock for every 1 share of the target company, the resulting exchange ratio is 2:1 (i.e. 2 for 1). Importantly, in determining the exchange ratio, both the acquiring and the target company make assessments about their financial strength, which may take into account metrics such as book value, EPS, PAT, and dividends paid.
Key Learning Points
- The exchange ratio is calculated as the number of new shares issued by an acquiring company divided by the number of shares acquired in the target company
- There are two types of exchange ratios: 1) fixed exchange ratios and 2) floating exchange ratios
- The difference between the current share price of the target company and the price being paid by the buyer is known as acquisition premium – it is required to ultimately calculate the exchange ratio
Exchange Ratio – Formula
Given below is the formula to calculate the exchange ratio:
Exchange ratio = Number of acquirer’s new shares issued/Number of target shares bought
The acquirer’s new shares issued are calculated as:
Acquirer’s new shares issued = Equity issued to do the deal/Acquirer share price
A buyer wants to acquire 1,000 shares of the target company at $10 each (deal value = $10,000). They plan to finance this deal 100% with equity and are willing to issue 2,000 of their own shares valued at $5 to pay for $10,000. The transaction’s exchange ratio will be 2 to 1 (2,000/1,000).
Dividing the equity issued by the acquirer’s share price ($10,000/$5) gives the number of shares issued by the acquirer (2,000 shares).
Types of Exchange Ratios
The share prices of both the buyer and the target company can experience fluctuations and can change between the initial offer stages to the deal closing date. M&A deals are typically structured with either a fixed or a floating exchange ratio.
Fixed Exchange Ratio
A fixed exchange ratio is the ratio of how many new acquirer shares are offered in exchange for each target company share and this remains fixed during the course of the deal. The shares issued are known, however, the value of the deal is unknown. The fixed exchange ratio is preferred by the acquiring company.
Floating Exchange Ratio
A floating exchange ratio is a ratio which floats such that the target company receives a fixed value, regardless of what happens to either the shares of the acquirer or the target company. Here the value of the deal is known but shares issued are unknown. The floating exchange ratio is preferred by the target company
Example: Exchange Ratio
Given below is some information pertaining to an acquisition. Using the assumptions below, the exchange ratio and the number of new shares to be issued in the transaction have been calculated.
Let us review some of the information given:
- Synergies are where two companies, when combined, can create greater value than on a standalone basis
- In this acquisition, the combined entity will likely benefit from SG&A synergies (cost savings in SG&A expenses) of $2,000
- The acquisition premium is the difference between the current share price of the target and the price being paid by the buyer
- Next, we calculate the equity purchase price as the current share price plus the acquisition premium multiplied by the diluted shares outstanding
As the buyer is paying this purchase price in shares, we need to work out how many shares must be issued. This is calculated as the equity purchase price divided by the buyer’s current share price.
So, the buyer needs to issue 1,294 new shares to purchase 1,200 shares of the target company. Based on this information, we calculate the exchange ratio as 1294/1200 = 1.1. In other words, the target company’s shareholders receive 1.1 shares of the buying company in exchange for their 1 share.