An exchange ratio is a financial calculation of fairly specific intent, that is generally used only when one publicly-owned company is the target of acquisition by another. In technical terms, it is the number of shares in the new company that a shareholder can expect to receive, in exchange for his shares in the old company. An exchange ratio, in principle, attempts to account for the differences in existing risk between two merging companies.
There are various methods by which an exchange ratio is calculated. Generally, stock valuations are conducted by third party brokers to determine the price of an individual share for both companies, and are specified in the contract between the two businesses. Brokers typically charge a percentage of the overall total of the transaction as payment.
Like all ratios, an exchange ratio is essentially a way of expressing a numerical fraction. In many cases the top number of the fraction, known as the numerator, is the average price per share of one of the companies — and the bottom number, the denominator, is the initial public offering (IPO) price of the other company. This is hardly a rule, however, and it is up to the companies themselves to negotiate the terms of the exchange ratio. Other factors that can play a part in determining it include, but are certainly not limited to, outstanding number of shares, outstanding debt, the market value of any equity, and cash flow.
Typically, a target company's shares are given a premium price above what the value of the company's stocks themselves would sell for in open trading. This is generally done as a way to sweeten the deal for shareholders who may otherwise be reticent about the transaction. A ten to 20% is not unusual, though higher and lower offers may be made depending on the circumstances of a particular offer. Shareholders on both sides ultimately vote on whether or not to accept the deal, and the shares are sold en masse to complete the acquisition.
By the nature of an exchange ratio, it is not applied when a private company in involved in the transaction, as these are not publicly traded and have no shareholders. In such cases, accountants attempt to evaluate the private company's assets, revenue, credit or bond rating, and other criteria to determine an agreeable purchase price. In such a case, rather than shareholders, it is up to company ownership to decide on the sale.
