Floating Exchange Ratio

A Floating Exchange Ratio is a term you'll encounter in the world of mergers and acquisitions (M&A), specifically in deals where one company buys another using its own stock instead of cash. Think of it as a “value-protection” plan for the company being bought. In a deal with a floating ratio, the exact number of shares the selling shareholders will receive isn't locked in when the deal is announced. Instead, the deal is defined by a fixed price per share for the target company. The number of the acquirer's shares needed to meet that price “floats” up or down based on the acquirer's stock price during a specified period just before the deal is finalized. This is the opposite of a fixed exchange ratio, where the number of shares is fixed, but the final dollar value of the deal fluctuates. With a floating ratio, the target company's shareholders know exactly how much money they're getting; they just don't know the precise share count until the very end.

Let's make this simple. Imagine Acquirer Inc. wants to buy Target Co. in a stock-for-stock transaction. They agree that each share of Target Co. is worth $20. This $20 price tag is locked in. The “floating” part is how Acquirer Inc. will pay that $20. The final exchange ratio is determined by Acquirer Inc.'s average stock price over the 10 days before the deal closes.

• Scenario 1: Bullish Days. If Acquirer Inc.'s stock is trading at an average of $40 during that period, then for every share of Target Co., a shareholder will receive $20 / $40 = 0.5 shares of Acquirer Inc.
• Scenario 2: Bearish Days. If the market sours and Acquirer Inc.'s stock drops to an average of $25, the ratio adjusts. To make up the $20 value, a Target Co. shareholder now receives $20 / $25 = 0.8 shares of Acquirer Inc.

Notice how the target shareholder gets $20 worth of stock in both cases. The number of shares they receive floats to ensure that value promise is kept.

The choice between a floating and fixed ratio reveals a lot about the negotiation and the risks each side is willing to take.

This is all about certainty. A deal can take months to close after it's announced. During that time, the acquirer's stock could plummet for any number of reasons (a bad earnings report, market panic, etc.). A floating ratio acts as an insurance policy for the target's shareholders. It guarantees them the agreed-upon price, protecting them from the acquirer's stock volatility. This makes it much easier for the target's board and shareholders to approve the deal.

Here, the shoe is on the other foot. The acquirer is taking on all the price risk. If their stock price falls, they have to issue more and more shares to pay for the acquisition. This leads to greater dilution, meaning each existing share represents a smaller piece of the company pie. This can be very unpopular with the acquirer's own shareholders. An acquirer agrees to this usually for one of two reasons:

• They are extremely confident their stock price will remain stable or rise.
• They are desperate to acquire the target and a floating ratio is the only way to get the deal done.

As a value investor, you're trained to look past the headlines and analyze the underlying mechanics of a deal. A floating exchange ratio tells a story.

A floating ratio is generally a good thing, as it locks in the value of your payout. You've essentially sold your shares for a fixed price. Your main decision is whether you want to hold the acquirer's shares after the deal closes or sell them immediately. Your analysis should shift to the acquirer: Is it a great business you want to own for the long term, or did you just get a ticket to a company you'd rather not be involved with?

Proceed with caution. Management is essentially writing a blank check, where the final cost depends on the whims of the market. This can be a major red flag. It exposes you, the owner, to potentially massive dilution. You need to ask tough questions: Is management overpaying? Are they so focused on empire-building that they are ignoring the cost to existing shareholders? However, to manage this risk, many deals include a safeguard.

To prevent extreme outcomes, many deals use a floating ratio within a protective band known as a collar. A collar sets a floor and a ceiling for the acquirer's stock price.

• How it works: The exchange ratio will float as long as the acquirer's stock price stays within a pre-agreed range (e.g., between $35 and $45).
• If the price drops below the floor ($35): The ratio might become fixed. This protects the acquirer from having to issue an insane number of shares.
• If the price rises above the ceiling ($45): The ratio might also become fixed. This allows the target's shareholders to share in some of the upside if the acquirer's stock soars.

A collar is a smart compromise that tries to balance the desire for price certainty (for the target) with the need to control dilution (for the acquirer). When you see a collar in a deal, it shows that both sides have thought carefully about managing risk.