Exchange Ratio: Formula and How to Calculate

When two companies undergo a merger or acquisition, shareholders of the acquired company often receive shares of the acquiring company instead of cash. The number of new shares is determined by the exchange ratio, a straightforward formula that compares the price offered per share of the target company to the current share price of the acquiring company. It has a direct impact on shareholder value and how much ownership an investor in the target company will hold in the newly combined entity.

If you have to make a corporate transaction, working with a financial advisor could help you assess how the exchange ratio impacts your portfolio.

Why the Exchange Ratio Matters

The exchange ratio determines how ownership is divided in the combined company and directly affects the value shareholders receive from the transaction. A favorable exchange ratio can enhance a shareholder’s position. But an unfavorable one may result in dilution or a diminished stake in the merged entity.

For the average investment portfolio, the exchange ratio is key to understanding whether a deal provides fair value. If a shareholder receives fewer shares than expected, or if the exchange ratio undervalues the target company, it could lead to resistance to the deal. In contrast, a well-structured ratio can build investor confidence and signal alignment between companies. In addition to influencing share count, the exchange ratio can impact voting rights, dividend prospects and future capital gains.

Exchange Ratio: Formula and Calculation

The exchange ratio determines how many shares of the acquiring company will be issued for each share of the target company. Here’s how it works:

Exchange Ratio = Offer Price per Target Company Share ÷ Acquirer’s Share Price

For example, say the acquiring company’s stock is trading at $50 per share. However, the offer values the target company at $40 per share. In this case, the exchange ratio would be:

Exchange Ratio = $40 ÷ $50 = 0.8

This means shareholders of the target company would receive 0.8 shares of the acquiring company for each share they own. The ratio determines how much of the merged company each investor controls. Even small changes in the calculation can lead to significant changes in perceived value.

Exchange Ratio: Different Types

Market conditions and negotiation terms can affect the structure of an exchange ratio. The following are some of the different types of exchange ratios you might encounter:

Fixed exchange ratio. This sets a specific number of acquiring company shares per target company share, regardless of market trends. If the acquirer’s share price drops before the deal closes, the target shareholders bear the loss. However, if it rises, they benefit.
Floating exchange ratio. A floating ratio adjusts based on the acquirer’s stock price to maintain a consistent dollar value for the target company shares. This protects the target company’s shareholders from stock price volatility.
Collar exchange ratio. A collar exchange ratio combines features of both fixed and floating ratios. It uses a range (or collar) for the acquirer’s share price to determine whether the exchange ratio remains fixed or adjusts. This offers some protection to both parties during periods of volatility.
Symmetric and asymmetric collars. Symmetric collars allow for equal adjustments in the exchange ratio whether the acquirer’s stock price goes up or down. Asymmetric collars can favor one party more than the other based on the structure of the collar range. This means they offer unequal protection in case of price movements.

Frequently Asked Questions

Is a Higher Exchange Ratio Better for Target Shareholders?

Generally, yes. A higher ratio means target shareholders receive more shares of the acquiring company, increasing their stake in the merged entity. However, the quality and value of the acquiring company’s shares also matter.

Can the Exchange Ratio Change After the Deal Is Announced?

Yes, in the case of floating or collar exchange ratios. The final ratio may adjust based on the acquiring company’s stock price leading up to the closing date.

Does the Exchange Ratio Affect Taxes?

In many cases, stock-for-stock exchanges in mergers are structured to be tax-deferred unless cash or other compensation is involved. A tax consultant can help clarify your situation.

Bottom Line

An investor reviewing her investment portfolio.

Investors use the exchange ratio to determine how to allocate shares during mergers and acquisitions. For shareholders of the target company, it sets the terms for their new ownership in the acquiring company and affects the overall value they receive. Whether the ratio is fixed, floating or collar-based, it can significantly impact financial outcomes. Especially if stock prices change leading up to the deal’s completion.

Investment Planning Tips

A financial advisor can help you mitigate risk for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you want to know how much you could pay in taxes for the sale on an investment, SmartAsset’s capital gains calculator can help you get an estimate.