What is the Exchange Ratio
The exchange ratio is the relative number of new shares that will be given to existing shareholders of a company that has been acquired or that has merged with another. After the old company shares have been delivered, the exchange ratio is used to give shareholders the same relative value in new shares of the merged entity.
BREAKING DOWN Exchange Ratio
An exchange ratio is designed to give shareholders an asset with the same relative value of the asset delivered upon the acquisition of the acquired company. Relative value does not mean, however, that the shareholder receives the same number of shares or same dollar value based on current prices. Instead, the intrinsic value of the shares and the underlying value of the company are considered when coming up with an exchange ratio.
Example of Exchange Ratio
The exchange ratio in a merger and acquisition is the opposite of a fixed value deal in which a buyer offers a dollar amount to the seller, meaning that the number of shares or other assets backing the dollar value can fluctuate in an exchange ratio. For example, imagine that the buyer offers the seller 2 shares of the buyer's company in exchange for 1 share of the seller's company. Prior to the announcement of the deal, the buyer's or acquirer's shares may be trading at $10, while the seller's or target's shares trade at $15. Due to the 2 to 1 exchange ratio, the buyer is effectively offering $20 for a seller share that is trading at $15.
Fixed exchange ratios are usually limited by caps and floors to reflect extreme changes in stock prices. Caps and floors prevent the seller from receiving significantly less consideration than anticipated, and they likewise prevent the buyer from giving up significantly more consideration than anticipated. Exchange ratios can also be accompanied by a cash component in a merger or acquisition, depending on the preferences of the companies involved in the deal.
Post announcement of a deal, there is usually a gap in valuation between the seller's and buyer's shares to reflect time value of money and risks. Some of these risks include the deal being blocked by the government, shareholder disapproval, or extreme changes in markets or economies. Taking advantage of the gap, believing that the deal will go through, is referred to as merger arbitrage and is practiced by hedge funds and other investors. Leveraging the example above, assume that the buyer's shares stay at $10 and the seller's shares jump to $18. There will be a $2 gap that investors can secure by buying 1 seller share for $18 and shorting 2 buyer shares for $20. If the deal closes, investors will receive 2 buyer shares in exchange for 1 seller share, closing out the short position and leaving investors with $20 in cash. Minus the initial outlay of $18, investors will net $2.