With the stock market trending up and sustained high interest rates for debt financing, many acquirors are using their stock as acquisition consideration. Use of stock as acquisition consideration preserves an acquiror’s cash for other uses and is a method of financing a deal without adding leverage to the acquiror’s balance sheet. In addition, using stock consideration can help align incentives and share risk between the acquiror and the target, since the target stockholders will hold shares in the pro forma company after closing.
The key concept when structuring a public company acquisition using stock consideration is the exchange ratio, which has value protection implications for both acquiror and target stockholders.
Fixed Exchange Ratios. By far, the most common approach is the fixed exchange ratio, in which each target share is exchanged for a fixed number of acquiror shares. Because the number of acquiror shares to be issued to target stockholders at closing is fixed, the actual value delivered at closing is subject to the fluctuation of the acquiror’s stock price in the interim period. In the event of a relative increase in the acquiror’s stock price between signing and closing, the acquiror effectively pays more for the target than its valuation – but by the same token, the target stockholders bear any risk that the acquiror’s shares decrease in value after signing. The fixed exchange ratio is the gold standard for acquirors because, among other things, the acquiror knows exactly how many shares it will need to issue at closing and therefore how much dilution its existing stockholders face and whether it will need a buyside stockholder vote under the Nasdaq or NYSE “20% rule”.
Floating Exchange Ratios. The alternative to the fixed exchange ratio is a floating exchange ratio. As with the fixed exchange ratio, the exchange ratio equals the per share offer price divided by the acquiror stock price, but in this case the exchange ratio “floats” to the deal value as the acquiror stock price fluctuates between signing and closing. The floating exchange ratio is appealing to the target because it solves for acquiror stock price volatility by locking in the dollar value delivered to target stockholders. However, having no lower or upper limit on the number of acquiror shares to be issued is challenging for the acquiror for the inverse of the reasons described above. Although floating exchange ratios without collars are almost never used in public company acquisitions, it did feature in Revolution Medicines’ acquisition of EQRx in 2023 with mitigating factors. The exchange ratio was blended, with 20% fixed based on the acquiror’s stock price leading up to signing, and 80% floating based on a 6% discount to the 5-day VWAP shortly prior to the stockholder meetings to vote on the transaction. Since a buy-side vote was already being sought, there would not have been a concern about inadvertently triggering a vote with a >20% stock issuance. In addition, because the floating “stopped” prior to the buy-side vote on the transaction, acquiror stockholders knew the amount of dilution they would face before they voted on the transaction.
“Fixed Value Collars”. Many of the acquiror-side concerns regarding a floating exchange ratio can be mitigated using a mechanism referred to as a “collar”. For example, Netflix’s original merger agreement (since amended to be an all-cash merger) for the acquisition of Warner Brothers Discovery used a common approach to a collar for the stock component of the consideration: WBD stockholders would receive $4.50 worth of Netflix stock per WBD share so long as the VWAP of Netflix’s stock shortly prior to closing was within a 10% symmetrical collar, outside of which the exchange ratio was fixed. Thus, WBD stockholders would receive 0.0460 Netflix shares per WBD share if the VWAP of Netflix's stock were below $97.91 and 0.0376 Netflix shares if the VWAP were above $119.67. WBD stockholders would have some protection against acquiror stock price volatility as their $4.50 in value was fixed no matter where Netflix stock trades inside of the collar. Below $97.91, however, the value realized by WBD stockholders would be exposed to downward movement in Netflix’s stock price, and above $119.67, WBD stockholders would participate in the upside. While WBD stockholders would have enjoyed value protection inside of the collar, the upper and lower bounds of the collar would have provided Netflix with a minimum and maximum number of shares that it would need to issue at closing.
“Reverse Collars”. Another construct uses a fixed exchange ratio within a specified price band for the average acquiror stock price, but outside of that band, the exchange ratio switches to floating. If the average price of the acquiror stock is between the floor and the ceiling price, then the number of acquiror shares issued to target stockholders is fixed and the value that the target stockholders receive fluctuates. If the average acquiror stock price falls below the floor or rises above the ceiling, then the number of acquiror shares issued to target stockholders either increases or decreases to ensure that the stock consideration has either a minimum dollar value or a maximum dollar value. The danger of this approach is that there is no limit to the number of acquiror shares that would have to be issued to ensure the floor value is met. For that reason, this structure is often accompanied by a cap on the amount by which the acquiror would need to increase the exchange ratio. Similarly, sometimes this approach is accompanied by a limit on how low the exchange ratio can go in the event the acquiror’s stock price increases significantly above the ceiling. In other words, sometimes a fixed value collar will be utilized to limit the impact of a reverse collar.
Walkaway Rights. A less common mechanism that can be paired with a fixed or floating exchange ratio is a walkaway right. Walkaway rights can take the form of a termination right on the target side if the acquiror stock price drops below a certain price (thereby not providing enough value to target stockholders), and/or an acquiror termination right if the acquiror stock price exceeds a certain price (thereby causing the deal to be too expensive for the acquiror). The downside protection for the target is typically subject to the right of the acquiror to “top up” the consideration by providing a greater number of acquiror shares per target share. Likewise, the upside protection can be subject to the right of the target to accept fewer acquiror shares per target share.
Using stock as consideration in public company M&A can offer acquirors significant strategic and financial flexibility, so it is important to understand how the structuring of the exchange ratio impacts value certainty on both sides of a transaction.
