What Is an Exchange Ratio of Shares?

Definition and Example of an Exchange Ratio

Exchange ratio refers to the number of new shares that shareholders of a new or acquiring company will receive relative to the number of shares of the target firm they own.

To see how an exchange ratio works in practice, look to the 2018 acquisition of Time Warner by AT&T, which was announced nearly two years prior. The companies used the volume-weighted averages of each company’s stock price for the 15 consecutive trading days before the close of the transaction.

Per the agreement, each Time Warner shareholder received 1.437 shares of AT&T common stock for each share of Time Warner stock they owned. AT&T also issued $53.75 per share in cash to Time Warner shareholders. Ultimately, about 1.19 billion shares of AT&T stock were issued to Time Warner shareholders.

How an Exchange Ratio Works

When two companies go through a merger or acquisition, the shareholders either receive cash for their shares, or ultimately become shareholders of either the acquiring company or the newly created company. An exchange ratio is necessary to determine how many shares each existing shareholder should receive. The exchange ratio is usually outlined in the merger or acquisition agreement.

When a fixed exchange ratio is used, each share of the target company’s stock is converted into a specific number of the acquiring company’s shares. The exchange ratio is laid out in the merger or acquisition agreement, and it doesn’t change.

Alternatively, a floating exchange ratio requires that the number of shares each shareholder of the target company receives be based on the market price of each stock at the time the deal closes. When a floating exchange ratio is used, no one knows at the time of signing the agreement what the exchange ratio will ultimately be. A floating exchange ratio was used in the AT&T acquisition of Time Warner.

In the case of the AT&T-Time Warner transaction, the agreement laid out different scenarios based on the stocks’ market price in the days leading up to the deal’s close. It stated that:

• If the average AT&T stock price was between $37.411 and $41.349, then the exchange ratio would be $53.75, divided by the average stock price.
• If the average AT&T stock price was greater than $41.349, then the exchange ratio would be 1.30.
• If the average AT&T stock price was less than $37.411, then the exchange ratio would be 1.437.

It happened that AT&T’s average stock price was less than $37.411 when the deal closed, resulting in each Time Warner shareholder receiving 1.437 shares of AT&T per share of Time Warner they owned.

What It Means for Individual Investors

As an investor, the concept of exchange ratio could be important to you if a company whose stock you own undergoes a merger or acquisition. Many companies try to ensure that shareholders receive the same relative value of ownership in the new company as they had in the previous company. However, that’s not always the case.

There are different strategies for calculating exchange ratio. In some cases, a fixed exchange ratio is used. In this case, as mentioned, the exchange ratio is outlined in the initial merger or acquisition agreement, and changes in the stock price prior to the deal’s close don’t have an impact. Changes in the stock price could ultimately change the value of the stock you get in the new company.

A poorly calculated exchange ratio could harm either the investors of the target company or the investors of the acquiring company. In a case where the exchange ratio is too high, the acquiring company’s shareholders ultimately lose value in their stakes in the company. On the other hand, an exchange ratio that’s too low harms the shareholders of the target company.

Remember that as a shareholder, you have the right to vote on mergers and acquisitions. In the case of the AT&T acquisition of Time Warner, Time Warner held a special stockholders’ meeting at which each investor had the opportunity to vote on the terms of the acquisition as they were laid out in the agreement. If you feel the terms of a merger or acquisition could be disadvantageous to you as an investor, you can voice your opinion at a shareholders’ meeting through your vote.