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Exchange Ratios in M&A: Fixed vs Floating Exchange Ratios, Collars and Caps

This article is part of a series on Mergers and Acquisitions

For a deal structured as a stock sale (as opposed to when the acquirer pays with cash — read about the difference here), the exchange ratio represents the number of acquirer shares that will be issued in exchange for one target share. Since acquirer and target share prices can change between the signing of the definitive agreement and the closing date of a transaction, deals are usually structured with:

  1. A fixed exchange ratio: the ratio is fixed until closing date. This is used in a majority of U.S. transactions with deal values over $100 million.
  2. A floating exchange ratio: The ratio floats such that the target receives a fixed value no matter what happens to either acquirer or target shares.
  3. A combination of a fixed and floating exchange, using caps and collars.

The specific approach taken is decided in the negotiation between buyer and seller. Ultimately, the exchange ratio structure of the transaction will determine which party bears most of the risk associated with pre-close price fluctuation.  BThe differences described above can be broadly summarized as follows:

Fixed exchange ratioFloating exchange ratio
  • Shares issued are known
  • Value of transaction is unknown
  • Preferred by acquirers because the issuance of a fixed number of shares results in a known amount of ownership and earnings accretion or dilution
  • Value of transaction is known
  • Shares issued are unknown
  • Preferred by sellers because the deal value is defined (i.e. the seller knows exactly how much it is getting no matter what)

Fixed exchange ratio

Below is a fact pattern to demonstrate how fixed exchange ratios work.

Terms of the agreement

  • The target has 24 million shares outstanding with shares trading at $9; The acquirer shares are trading at $18.
  • On January 5, 2014 (“announcement date”) the acquirer agrees that, upon completion of the deal (expected to be February 5, 2014) it will exchange .6667 of a share of its common stock for each of the target’s 24 million shares, totaling 16m acquirer shares.
  • No matter what happens to the target and acquirer share prices between now and February 5, 2014, the share ratio will remain fixed.
  • On announcement date, the deal is valued at: 16m shares * $18 per share = $288 million. Since there are 24 million target shares, this implies a value per target share of $288 million/24 million = $12. That’s a 33% premium over the current trading price of $9.

Acquirer share price drops after announcement

  • By February 5, 2014, the target’s share price jumps to $12 because target shareholders know that they will shortly receive .6667 acquirer shares (which are worth $18 * 0.6667 = $12) for each target share.
  • What if, however, the value of acquirer shares drop after the announcement to $15 and remain at $15 until closing date?
  • The target would receive 16 million acquirer shares and the deal value would decline to 16 million * $15 = $240 million. Compare that to the original compensation the target expected of $288 million.

Bottom line: Since the exchange ratio is fixed, the number of shares the acquirer must issue is known, but the dollar value of the deal is uncertain.

Real World Example

CVS’s 2017 acquisition of Aetna was partially funded with acquirer stock using a fixed exchange ratio. Per the CVS merger announcement press release, each AETNA shareholder receives a 0.8378 CVS share in addition to $145 per share in cash in exchange for one AETNA share.

Floating exchange (fixed value) ratio

While fixed exchange ratios represent the most common exchange structure for larger U.S. deals, smaller deals often employ a floating exchange ratio. Fixed value is based upon a fixed per-share transaction price. Each target share is converted into the number of acquirer shares that are required to equal the predetermined per-target-share price upon closing.

Let's look at the same deal as above, except this time, we'll structure it with a floating exchange ratio:

  • Target has 24 million shares outstanding with shares trading at $12. Acquirer shares are trading at $18.
  • On January 5, 2014 the target agrees to receive $12 from the acquirer for each of target’s 24 million shares (.6667 exchange ratio) upon the completion of the deal, which is expected happen February 5, 2014.
  • Just like the previous example, the deal is valued at 24m shares * $12 per share = $288 million.
  • The difference is that this value will be fixed regardless of what happens to the target or acquirer share prices. Instead, as share prices change, the amount of acquirer shares that will be issued upon closing will also change in order to maintain a fixed deal value.

While the uncertainty in fixed exchange ratio transactions concerns the deal value, the uncertainty in floating exchange ratio transactions concerns the number of shares the acquirer will have to issue.

  • So what happens if, after the announcement, the acquirer shares drop to $15 and remain at $15 until the closing date?
  • In a floating exchange ratio transaction, the deal value is fixed, so the number of shares the acquirer will need to issue remains uncertain until closing.

Collars and caps

Collars may be included with either fixed or floating exchange ratios in order to limit potential variability due to changes in acquirer share price.

Fixed exchange ratio collar

Fixed exchange ratio collars set a maximum and minimum value in a fixed exchange ratio transaction:

  • If acquirer share prices fall or rise beyond a certain point, the transaction switches to a floating exchange ratio.
  • Collar establishes the minimum and maximum prices that will be paid per target share.
  • Above the maximum target price level, increases in the acquirer share price will result in a decreasing exchange ratio (fewer acquirer shares issued).
  • Below the minimum target price level, decreases in the acquirer share price will result in an increasing exchange ratio (more acquirer shares issued).

Floating exchange ratio collar

The floating exchange ratio collar sets a maximum and minimum for numbers of shares issued in a floating exchange ratio transaction:

  • If acquirer share prices fall or rise beyond a set point, the transaction switches to a fixed exchange ratio.
  • Collar establishes the minimum and maximum exchange ratio that will be issued for a target share.
  • Below a certain acquirer share price, exchange ratio stops floating and becomes fixed at a maximum ratio. Now, a decrease in acquirer share price results in a decrease in value of each target share.
  • Above a certain acquirer share price, the exchange ratio stops floating and becomes fixed at a minimum ratio. Now, an increase in acquirer share price results in an increase in the value of each target share, but a fixed number of acquirer shares is issued.

Walkaway rights

  • This is another potential provision in a deal that allows parties to walk away from the transaction if acquirer stock price falls below a certain predetermined minimum trading price.
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