Exchange ratio definition
/What is the Exchange Ratio?
The exchange ratio is the number of acquirer shares that will be given to the shareholders of an acquiree, based on their current share ownership of the acquiree. The ratio is designed to give these shareholders the same relative value in the acquirer’s shares. These shareholders should receive greater value if the acquirer paid a premium to buy the acquiree. However, this value may decline rapidly if the investment community believes the acquirer overpaid, in which case investors will sell their shares, lowering their market value.
A proposed exchange ratio is usually restricted by a cap and floor, to keep the acquirer from having to pay more consideration than expected, and to ensure that the acquiree’s shareholders are eventually paid as much as they expect to receive.
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The Fixed Exchange Ratio
When an acquirer offers a fixed exchange ratio, the proposed ratio is not altered through the closing date of the acquisition. This means that the number of shares to be issued is known. However, the value of these shares is uncertain, since the market price of the acquirer’s shares is fluctuating over time. This approach favors the acquirer, since it knows in advance the proportion of acquirer ownership that it is giving up to the shareholders of the acquiree.
The Floating Exchange Ratio
When an acquirer offers a floating exchange ratio, the proposed ratio floats until the closing date. This allows the shareholders of the acquiree to receive a fixed value. This means that the number of shares to be issued is uncertain, while the deal’s value is known. This approach favors the acquiree’s shareholders, since they know in advance the amount they will be paid. Conversely, it does not favor the acquirer, which will be uncertain of the number of shares it must give up until the closing date.
Acquisition Arbitrage
When these deals are announced, there may be a gap between the prices of the shares in the two companies that represents an arbitrage opportunity. This usually means that the shares of the acquiree are priced too low by the market, perhaps due to uncertainty that the proposed deal will not be completed. When this is the case, investors can buy the shares of the acquiree, and will profit from the exchange ratio when the deal is eventually completed.
Example of the Exchange Ratio
International Tuna offers the shareholders of Icelandic Cod Corporation one share of International Tuna stock in exchange for every four shares of their Icelandic Cod stock. At the announcement of the deal, International Tuna’s stock was selling for $10 per share, while Icelandic Cod’s was selling for $2.50 per share. Due to the 4:1 exchange ratio, International Tuna is essentially offering to buy Icelandic Cod for its current market value.