Exchange Ratios in M&A Deals: Fixed, Floating, and Collars (20:05)

In merger models, people often assume that the Buyer uses specific percentages of Cash, Debt, and Stock to acquire the Seller.

But in real life, it’s more common to use an Exchange Ratio in 100% Stock deals, where the Seller receives X new shares of the Buyer for each 1 of its own shares.

To figure out this Exchange Ratio, you could start with the control premium the Buyer is willing to pay.

For example, if the Seller’s Current Share Price is $20.00, and the Buyer is willing to pay a 25% premium, the offer price is $25.00 per share.

If the Buyer’s Current Share Price is $20.00, then the Exchange Ratio = Offer Price / Buyer’s Share Price = $25.00 / $20.00 = 1.25x.

If this Exchange Ratio is Fixed, then the Seller will get 1.25 of new shares from the Buyer for each 1 of its shares.

Motivations for Other Exchange Ratios

The most serious problem here is that if the Buyer’s Share Price falls, the Seller will get a lower purchase price because the Buyer’s shares will be worth less!

One solution is to use a Floating Exchange Ratio, which guarantees a fixed Equity Purchase Price, but which allows the number of shares issued to the Seller to vary.

For example, maybe the Equity Purchase Price is fixed at $125 million.

If the Buyer’s Share Price is $20.00, the Seller will get 6.25 million shares. But if the Buyer’s Share Price drops to $15.00, the Seller will get 12.5 million shares.

The Floating Exchange Ratio doesn’t “solve” these problems in a deal, though, because the Buyer and Seller might have different concerns.

The Buyer doesn’t want its share price to fall and lose ownership in the combined company as a result.

And the Seller wants as much ownership as possible and a somewhat stable price.

Fixed Exchange Ratio with a Collar

One compromise solution is a structure known as a Collar, which modifies the normal Fixed and Floating Exchange Ratios and changes their behavior in certain share price ranges.

If it’s a Fixed Exchange Ratio with a Collar, the Exchange Ratio is constant within a certain range of Buyer share prices (between the “Floor” and “Cap”) but can change outside that range.

For example, if the Buyer’s Share Price is between $15.00 and $25.00, maybe the Exchange Ratio remains Fixed at 1.25x.

Below $15.00, though, the Buyer must issue additional shares such that the Seller receives a minimum purchase price of $93.8 million.

And above $25.00, the Buyer must issue fewer shares such that the Seller receives a maximum purchase price of $156.3 million.

This structure makes it a bit easier to negotiate a deal because both sides get some risk protection.

The Seller always knows the purchase price range, and the Buyer has an idea of what its ownership will be.

Floating Exchange Ratio with a Collar

If it’s a Floating Exchange Ratio with a Collar, the Exchange Ratio varies within a range of Buyer Share Prices but becomes Fixed outside it.

For example, maybe the baseline Exchange Ratio is 1.250x, which increases as the Buyer’s Share Price falls and decreases as the Buyer’s share price rises.

But above a 1.667x ratio (Buyer Share Price of $15.00), it remains constant at 1.667x, so the purchase price drops but the Seller’s ownership stays the same.

And below 1.000x (Buyer Share Price of $25.00), it remains constant at 1.000x, so the purchase price increases but the Seller’s ownership stays the same.

The Floating Exchange Ratio with a Collar sets a floor and a cap for the Seller’s ownership, so it’s often the best solution if the main concern of both sides is ownership.