A stock exchange ratio is a crucial metric that directly impacts the ownership stake and compensation for shareholders in all-stock and stock-and-cash deals. Understanding the stock exchange ratio can help shareholders evaluate fairness in Merger and Acquisition (M&A) transactions and anticipate any future changes in voting power. This article explores the two types of exchange ratios in M&A transactions, along with real-world examples and shareholder impact considerations.
What is an exchange ratio?
M&A transactions often involve a share exchange ratio. It is the rate at which the acquirer’s shares are exchanged for the target’s shares. It determines how many shares the target company’s existing shareholders will receive for every share they own.
This allows the target’s shareholders to maintain the same relative value of stock held in the target company. Share exchanges are typically used in the following types of transactions:
- Stock-for-stock mergers
An acquiring company pays the full acquisition price with its stock. It issues shares to the existing shareholders of the target company, who then become shareholders of the merged entity.
- Acquisitions with equity exchange
An acquiring company issues stock to the target company’s shareholders alongside cash. The existing shareholders of the target company then become shareholders of the acquiring company.
Since cash-and-stock and stock-for-stock transaction structures are rising in popularity among dealmakers — they made up 24% of overall announced U.S. deals in Q2 2024, the highest percentage since 2001 — it’s crucial to understand how stock exchange ratios are calculated.
How to calculate an exchange ratio?
The base exchange ratio is calculated using the following formula: Target share price ÷ acquirer share price. A share exchange ratio may be calculated based on acquiring and target companies’ market or book value.
Base M&A exchange ratio formula example
Here is an example of the base exchange rate formula with the following inputs:
- Target share price: $20
- Acquirer share price: $25
- Exchange ratio: $20 ÷ $25 = 0.8
- Value per target share: 0.8 × $25 = $20
The 0.8 exchange ratio means the target’s shareholders receive 0.8 of the acquirer’s shares for every share they own. The value per target share equals the target’s share price, which means the target’s shareholders don’t receive a premium.
Acquirers may adjust the basic exchange ratio to account for the premium they want to pay target shareholders. Here is what the exchange ratio looks like with a 30% premium:
- Target share price: $20
- Acquirer share price: $25
- 30% premium: $20 + 30% = $26
- Exchange ratio: $26 ÷ $25 = 1,04
- Value per share: 1,04 × $25 = $26 (reflects 30% premium)
In this example, the target’s shareholders receive 1.04 shares for every share they own. This means the target’s shareholders are offered the above-market value of the target company.
Market value method
The market value method considers the target company’s market value when calculating the equity purchase price. Market value is determined by the current share price multiplied by the number of shares outstanding. It can be a starting point for price considerations and exchange ratios during mergers and acquisitions. Here is an example:
- Target share trading price: $20
- Target’s number of shares outstanding: 10 million
- Target’s market capitalization: $20 × 10 million = $200 million
Let’s assume the acquirer offers a 20% premium over the target company’s current share price. Here is the calculation:
- 20% premium: $20 + 20% = $24
- Acquirer share trading price: $30
- Exchange ratio: $24 ÷ $30 = 0.8
- Value per target share: 0.8 × $30 = $24
This exchange ratio means the target’s shareholders receive 0.8 shares for every share they own. This means the acquirer exchanges eight million shares of their own company for 10 million shares of the target company.
Explore the peculiarities of the cash-for-stock exchange ratio in our dedicated article about cash vs stock M&A transactions.
Book value method
The book value method considers the target company’s intrinsic value (net asset value (NAV)). NAV is calculated using the formula: Total assets − total liabilities. Here is an example that illustrates the exchange ratio based on the net asset values of the target and acquiring companies:
- Target assets: $100 million
- Target liabilities: $30 million
- Target NAV: $100 million − $30 million = $70 million
- Acquirer assets: $200 million
- Acquirer liabilities: $60 million
- Acquirer NAV: $200 million − $60 million = $140 million
- Exchange ratio: $70 million ÷ $140 million = 0.5
In this example, the target’s shareholders receive 0.5 shares for every share they hold. If the acquirer pays, for example, a 20% premium, the exchange ratio will be adjusted to 0.5 + 20% = 0.6. The target company will be valued at $70 million + 20% = $84 million.
Factors that influence exchange ratios
Exchange ratios in mergers and acquisitions with equity considerations are influenced by many factors, including, but not limited to, the following:
- Market conditions and performance
The difference between the target and acquirer’s trading share price may influence exchange ratios. If the target’s shares are traded significantly lower than the acquirer’s, the exchange ratio may be less than 1. Conversely, a subtle difference in share prices may require a higher exchange ratio, greater than 1, to benefit the target’s shareholders.
- Premium offered
The exchange ratio may be higher if the target company receives a premium.
- Relative company size
A smaller target company may need fewer acquirer shares to be issued. This may result in a lower exchange ratio.
- Financial metrics and financial ratios in mergers and acquisitions
Acquirers may adjust exchange ratios to account for the financial metrics of target companies, used in the acquisition valuation process, such as earnings before interest, taxes, depreciation, and amortization (EBITDA), enterprise value (EV), earnings per share (EPS), and discounted cash flows (DCF).
Explore common M&A valuation methods and financial modeling examples in our dedicated article.
Types of exchange ratios in M&A
There can be a fixed or floating exchange ratio in M&A deals. Here’s an explanation of each type with examples.
Fixed exchange ratio
In fixed exchange ratio transactions, the number of acquirer’s shares issued to the target shareholders remains constant throughout the transaction. The exchange ratio remains the same, disregarding share price fluctuations.
This can result in beneficial or unfavorable outcomes for the target company’s shareholders. Here are the base merger terms and conditions, illustrated through examples of both fixed and floating exchange ratios:
- Target shares outstanding: 10 million
- Target share price: $20
- Acquirer share price: $30
- Exchange ratio: 0.8
- Value per target share: 0.8 × $30 = $24 (20% premium)
- Number of acquirer’s shares issued: 8 million
- Deal value: 8 million shares at $30 = $240 million
Positive scenario: Acquirer’s share price increased by 5%
After the deal announcement, the acquirer’s shares are trading at $31.5 (a 5% increase), which means a 5% increase in the target’s compensation. Since the target shareholders still receive eight million shares, the total compensation is: 8 million shares × $31 = $252 million, reflecting a 5% increase in the acquirer’s share price. This results in a new value per target share: 0.8 × $31.5 = $25.2 (a 5% increase from $24).
Negative scenario: Acquirer’s stock price falls 5%
After the stock transaction announcement, the acquirer’s shares are trading at $28.5 (a 5% decrease), which means a 5% decrease in the target’s compensation. The target shareholders still receive eight million shares, and the total compensation is 8 million shares × $28.5 = $228 million, reflecting a 5% decrease in the acquirer’s share price. This results in a new value per target share: 0.8 × $28.5 = $22.8 (a 5% decrease from $24).
When is the fixed exchange ratio appropriate?
The fixed exchange ratio may be appropriate when the acquirer wants to protect its ownership interest in the combined company and avoid excessive dilution impact on its shareholders (when new shares reduce existing shareholders’ ownership stake). This is also a good structure when the target shareholders are interested in receiving a predetermined number of shares.
Floating exchange ratio (fixed value)
The floating exchange ratio measures the number of acquirer’s shares adjusted for fixed deal value. This means the exchange ratio can change so shareholders receive the same dollar value, regardless of the buyer’s current share price. Here is how a floating exchange ratio works with share price fluctuations:
Positive scenario: Acquirer’s share price increased by 5%
After the deal announcement, the acquirer’s shares are trading at $31.5 (a 5% increase). The deal value remains constant at $240 million and $24 per target share. However, the exchange ratio is adjusted: $240 million ÷ $31.5 per share = 7.65 million shares, a 0.765 exchange ratio instead of 0.8. This means the target shareholders will receive fewer shares to reflect the fixed per-share value: 0.765 × $31.5 = $24.
Negative scenario: Acquirer’s share price dropped by 5%
After the deal announcement, the acquirer’s shares are trading at $28.5 (a 5% decline). The number of acquirer’s shares is increased to keep the deal value at $240 million and per-share value at $24: $240 million ÷ $28.5 = 8.42 million shares. This is a 0.842 exchange ratio instead of 0.8. This means the target shareholders will receive more shares to reflect the fixed per-share value: 0.842 × $28.5 = $24.
When is the floating exchange ratio appropriate?
A floating exchange ratio may be appropriate when the target company wants to secure the predetermined compensation, the acquirer’s stock is likely to fluctuate, or the deal may take longer to close than expected. This protects the target company’s shareholders from the acquirer’s pre-close share price fluctuations.
The significance of exchange ratios for shareholders
Unlike a buyout, meaning gaining full ownership over the target company, a stock-for-stock or a stock-and-cash merger structure results in shared ownership between the acquiring and target shareholders.
Given the shared ownership, exchange ratios can affect the shareholders of both companies, impacting ownership rights, voting power, and overall satisfaction with the deal.
How does a fixed exchange ratio affect shareholders?
Here is how a fixed exchange ratio affects shareholders:
- Ownership stake
Target shareholders benefit from a predetermined ownership stake, particularly at higher exchange ratios but may face financial losses when the current trading price drops.
- Voting power
Dilution reduces the voting power of the acquiring shareholders but in a predictable manner. Acquiring shareholders may prefer lower exchange ratios while target shareholders may be interested in higher exchange ratios.
- Overall satisfaction
Target shareholders may face uncertain financial outcomes, while acquiring shareholders may feel disadvantaged due to voting power dilution, particularly at high exchange ratios.
How does a floating rate affect shareholders?
Here is how a floating exchange rate impacts shareholders:
- Ownership stake
Target shareholders may face uncertainty in the ownership stake and be disadvantaged if the share price increases. Acquiring shareholders may face unpredictable dilution.
- Voting power
If the share price drops, target shareholders may benefit from greater voting power and vice versa. Acquiring shareholders may benefit from the share price increase because it means less dilution.
- Overall satisfaction
Overall satisfaction can be achieved if the deal structure balances the negatives of stock price and share issuance fluctuations.
When a company buys another company what happens to your stock? Find this out in our dedicated article.
Risks and challenges of exchange ratios in M&A negotiations
Exchange ratios can be affected by the following challenges during the merger and acquisition process:
- Market volatility
Typically beyond the control of merging companies, pre-close price fluctuations can cause disputes and slow the negotiation process down.
- Regulatory challenges
Regulatory approval delays can decrease share prices and lead to tension between both parties.
- Shareholder concerns
Shareholders may be concerned about power dilution. Acquiring and target shareholders may also have conflicting interests.
- Integration performance
Power imbalances and shareholder disputes may hinder the overall decision-making and integration processes.
How do caps and collars address exchange ratio risks?
The key feature of fixed ratios is predictability in ownership distribution. This may be more attractive for shareholders with a long-term vision that doesn’t consider short-term price fluctuations. Meanwhile, floating ratios require the use of caps and collars — balancing mechanisms to address ownership distribution fluctuations:
- Cap
This sets the upper limit to the exchange ratio, preventing the acquirer from issuing too many shares to target shareholders. For example, the exchange ratio can’t exceed 0.95.
- Collar
This keeps the exchange ratio within a certain range, catering to the interests of the target and acquiring shareholders. For example, the minimum value is limited to 0.75 while the maximum limit is 0.95.
Exchange ratio example: SiriusXM and Pandora
SiriusXM, a multinational audio entertainment company, acquired Pandora, a music streaming company, for approximately $3.5 billion in a stock-for-stock merger in 2019. Here is the exchange ratio data of the deal:
- Exchange ratio type: Fixed
- Pandora share price: $10.14
- SiriusXM share price: $7.04
- Exchange ratio: 1.44
- Premium offered: 13.8%
The merger agreement was signed in September 2018, and the deal was closed in February 2019. The deal’s exchange ratio remained at 1.44 at the closing date.
Exchange ratio example: Disney and Pixar
Disney, a multinational entertainment media company, acquired Pixar, a computer animation studio, for approximately $7.4 billion in an all-stock acquisition in 2006. Here is the exchange ratio data of the deal:
- Exchange ratio type: Fixed
- Pixar share price: $59.78
- Disney share price: $25.52
- Exchange ratio: 2.34
- Premium offered: 3.8%
The acquisition was announced in January 2006 and completed in May 2006. The deal’s exchange ratio remained at 2.34, and Pixar’s shareholders benefited from Disney’s 14% share price increase post-announcement.
The bottom line
- An M&A exchange ratio determines the number of shares in the acquiring company that will be exchanged for shares in the target company.
- A fixed exchange ratio remains unchanged throughout the deal, while a floating exchange ratio may be adjusted to reflect stock price fluctuations.
- Market price, financial health, business valuation metrics, and willingness to pay premiums typically influence the structure of stock exchange ratios.
- To address share price fluctuations, caps and collars can be applied to floating exchange ratios. A cap sets a maximum limit to the exchange ratio, while a collar keeps the ratio within ranges acceptable for both companies involved.
