Of course, M&A transactions don’t only have to be conducted with a cash purchase of the target company’s equity shares. Instead, the acquiring company can pay cash outright, convert the target company’s stock to its own or use a mixture of cash and stock. In order to convert stock of one company to that of another company, however, both companies need to agree on a particular exchange rate: the swap ratio.
Simply put, a swap ratio is the exchange rate between the shares of the companies that are undergoing an M&A transaction. For example, if the acquiring company is offering 5 shares of its own stock for every 1 share of the target company, the resulting swap ratio is 5:1. On the other hand, if the acquiring company is offering 1 share of its stock for 2 shares of the target company, the swap ratio will be 1:2.
How is a Swap Ratio Calculated?
Since there’s no precise formula for calculating the swap ratio in every situation, a great deal of work and thought goes into determining the swap ratio before carrying out the M&A transaction.
In order to set the swap ratio, both companies perform a number of calculations about their financial situations. This may include metrics such as:
- Book value
- Earnings per share
- Profits after tax
- Dividends paid
The final swap ratio may also take into account factors such as the size of the companies and the target company’s long-term debts, as well as subjective aspects such as the companies’ reasoning for the M&A transaction.
What are Swap Ratios Used For?
Swap ratios are important because they make sure that investors in either of the two companies are relatively unaffected by the M&A transaction. Shareholders will be able to preserve the same relative value when their existing shares are converted into shares for the merged company.
Since the merged company has the shares of both the target and the acquiring company, shareholders in the target company will have their current equity diluted by the new shares. However, this diluting effect is offset by the combination of both companies’ assets and liabilities. As a result, not only will the shares have the same relative value, they will hopefully appreciate as a result of the merger.
The swap ratio between the two companies’ shares is usually indicative of both companies’ relative size and value. If investors in the target company need to exchange multiple shares just to receive a single share in the acquiring company, then the acquiring company usually has a larger value and can have more influence during the negotiations. In addition, the swap ratio determines the influence that shareholders in both companies will have over the merged company and its board of directors.