What is the Exchange Ratio Formula?
The exchange ratio formula is meant to give its users the amount of new shares that a business buying another will have to issue in exchange for the business being bought. The formula is used in merger and acquisition deals.
The formula plays a significant role as it allows the buying investors and business to know how much of the bought company shares the company needs to compensate for through its own shares. It is specifically important when a merger and acquisition deal is going to be financed through the buying company’s shares. This is called a “share swap” in financing terms.
The exchange ratio formula is very useful in determining the mechanism of merger and acquisition deals that need equity financing.
The exchange ratio simply gives the proportion with which the buyer will be paying off the stockholders of the buyout candidate.
For example, if company A is buying company B by giving 1 of its shares for every 3 shares of company B, the exchange ratio is 1:3. This makes sense as it is giving one of its shares for every 3 shares that it gets.
What is important to know is that the exchange ratio is determined after extensive evaluations of the financial statements, the debt levels, market presence, etc.
Mainstream financial ratios like earnings per share, profit before (and after) tax, dividend payout ratios, and book value amongst others are all assessed.
The Formula for Exchange Ratio
To calculate the exchange ratio for two companies, the following formula can be used:
Exchange Ratio = Number of new shares released by the buyer / Number of shares bought
The number of new shares released by the buyer is obtained by:
Buyer’s new stock = Shares released for the deal/Buyer’s share price
Exchange Ratio Formula Illustration:
A company wants to buy 2,000 shares of the business it is acquiring at $20 per share (deal value = $40,000). The company intends to fund this transaction completely through its equity and is going to release 2,000 of its own stocks priced at $10 to fund the $40,000 needed. The transaction’s exchange ratio will be 1 to 2 (20,000/40,000).
Applying the exchange ratio formula and keeping the stock price of the buyer’s shares at $20 price ($40,000/$20) yields the amount of stock issued by the acquirer (2,000).
Complexities in Interpretation of the Exchange Ratio Formula
In some cases, the merger and acquisition deal is split in some proportion between cash and equity. In this situation, the percentage of stock and the market value of both companies' shares play an important role.
There are complications involved in such split deals and many deals have been canceled simply because both sides could not agree on a suitable exchange ratio.
Accounting for the exchange ratio is complicated when the total value of a business is being assessed.
Since most businesses have intangibles involved in their valuations, the metrics become complex and their interpretations are also subject to individual perspectives.
The concepts of value dilution and intangible valuation can impact the exchange ratio interpretation.
Categories of Exchange Ratios
The exchange ratio formula can be complicated to apply as the stock prices of all companies vary in secondary trading in the stock markets.
Both the buying and the bought company can face fluctuating prices, and these can move so much that the price and ratio can vary through the initial negotiations to the time the deal is about to close.
To accommodate this variation, many merger and acquisition deals are designed to have either a fixed or floating exchange rate ratio.
Fixed Exchange Ratio
In this ratio, the formula assesses the number of new shares issued by the buyer for the bought company’s shares. This number of shares is then fixed in the process of the deal. With the number of shares to be issued fixed, there is no role for the market fluctuations, and the exact monetary value of the deal is not known.
Most buying companies prefer this version.
Floating Exchange Ratio
As the name implies, a floating exchange ratio will vary. But this variation is managed in such a way that the business being bought will get a fixed amount, irrespective of what happens to the share prices or the exchange ratio.
In deals that use the floating exchange ratio, the amount of money exchanged is known, while the exact number of shares transferred is not known.
Most companies that are being sold off, prefer this category of exchange ratios
Importance of the Exchange Ratio
There is no use of the exchange ratio formula in case the company merger or buyout is done in cash. It is usually noted as nil or 0.0000 in the standard format of merger details.
At times some merger specialists show a notional value for the exchange ratio, based on the cash value of the merger and acquisition activity to give both the parties an idea of what they would be paying (and receiving) if they were to opt for equity backed transaction.
Similarly, if the situation is flipped and the transaction is fully equity backed, the exchange ratio formula becomes the most important metric for the transaction and all negotiations involved.
Conclusion
The exchange ratio formula can be a complex metric to apply due to the varying nature of stock prices. Share prices of most companies vary in secondary trading in the stock markets. Both the buying and the selling company experience increased fluctuation when the rumors start floating about merger and acquisition activity taking place.
In any case, the exchange ratio is useful to settle the purchase price of a company being acquired. It has different applications according to whether a floating r fixed exchange ratio is selected. In the case of mergers that are fully cash backed, the ratio will have no significance, except for comparison purposes.
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