Fixed vs. Floating Exchange Ratios in M&A: Share-Based Deals

Mergers and acquisitions (M&A) are complex beasts, and one of the most critical aspects to nail down in a share-based transaction is the exchange ratio.

This determines how many shares of the acquirer's stock target shareholders will receive for each of their shares.

Broadly, these ratios fall into two categories: fixed and floating.

Understanding the nuances of each is crucial for both buyers and sellers in navigating the inherent risks and rewards.

Fixed Exchange Ratio: Certainty in Share Count

A fixed exchange ratio specifies a predetermined number of acquirer shares for each target share. For example, a deal might stipulate that target shareholders will receive 0.5 shares of AcquirerCo for every 1 share of TargetCo they own.

How it works: The number of shares exchanged is set at the time the deal is agreed upon and does not change, regardless of how the stock prices of either company fluctuate before the deal closes.

Pros for the Seller (Target Company):

• Certainty of Ownership Stake: Target shareholders know exactly what percentage of the combined entity they will own post-acquisition.
• Upside Participation: If the acquirer's stock price increases between announcement and closing, the value of the consideration received by target shareholders also increases.

Cons for the Seller (Target Company):

• Downside Risk: Conversely, if the acquirer's stock price falls, the value of the consideration received by target shareholders decreases. This can lead to deal fatigue or even shareholder dissent if the drop is significant.

Pros for the Acquirer (Buyer Company):

• Fixed Dilution: The acquirer knows precisely how many new shares it will issue, allowing for clear calculation of earnings per share (EPS) dilution and ownership percentages.

Cons for the Acquirer (Buyer Company):

• Exposure to Acquirer Share Price Fluctuation: If the acquirer's stock price performs poorly, the deal could become more expensive in real terms (e.g., a higher multiple paid for the target).
• Risk of Overpaying: If the target's value drops relative to the acquirer's, the acquirer might end up paying more than intended in terms of market value.

Floating Exchange Ratio: Value-Based Transactions

A floating exchange ratio, also known as a fixed value exchange ratio, aims to deliver a specific monetary value to target shareholders. This means the number of acquirer shares exchanged will fluctuate to ensure the target shareholders receive a pre-agreed dollar value per share.

How it works: The ratio is determined by dividing the agreed-upon per-share value of the target by the average trading price of the acquirer's shares over a specified period (e.g., 20 trading days prior to closing).

Pros for the Seller (Target Company):

• Guaranteed Value: Target shareholders are assured of receiving a specific monetary value for their shares, irrespective of short-term fluctuations in the acquirer's stock price. This provides significant downside protection.

Cons for the Seller (Target Company):

• No Upside Participation: If the acquirer's stock price soars, target shareholders do not benefit from that appreciation beyond the agreed-upon value. They might receive fewer shares as a result.

Pros for the Acquirer (Buyer Company):

• Controlled Cost: The acquirer has a clear understanding of the total cash value they are paying for the target. This helps in budgeting and financial planning.
• Protection Against Acquirer Stock Price Appreciation: If the acquirer's stock performs well, they will issue fewer shares, mitigating dilution.

Cons for the Acquirer (Buyer Company):

• Uncertain Dilution: The number of shares to be issued is not fixed and can increase significantly if the acquirer's stock price declines, leading to greater dilution than initially anticipated. This can negatively impact EPS.
• Risk of Issuing Too Many Shares: If the acquirer's stock price drops considerably, they might have to issue a large number of shares, potentially impacting market perception and control.

Key Considerations and Hybrids

The choice between a fixed and floating exchange ratio often comes down to who bears the stock price risk.

• Fixed Ratio = Acquirer Stock Price Risk to Target Shareholders
• Floating Ratio = Acquirer Stock Price Risk to Acquirer Company

In practice, many deals incorporate collar mechanisms to mitigate extreme outcomes for both parties. A collar sets upper and lower limits on the exchange ratio in a floating deal, or on the value of the consideration in a fixed deal. This provides a band within which the value or share count can fluctuate, offering some protection against significant shifts in share price.

For example, a fixed exchange ratio might have a collar that states if the acquirer's share price falls below a certain threshold, the exchange ratio will adjust upwards to maintain a minimum value, or vice-versa.

Conclusion

The decision to opt for a fixed or floating exchange ratio is a strategic one, influenced by market conditions, the relative stability of each company's share price, and the negotiating power of both sides.