Proration

Proration Definition

Proration is a specific corporate action taken in case of merger or acquisition, share buyback or stock split etc. where the company offers the shareholders the option to select between cash and equity payout. Based on what the shareholders select, the available stocks are proportionately distributed among them if either cash or equity stocks are not available in sufficient quantity to satisfy the shareholder demand. Basically, the company ensures that everyone gets a fair share of the deal through the proportional division of both cash and shares.

Explanation

Now, let us take a hypothetical situation to explain the concept of proration in a corporate set-up. Let us assume that XYZ Inc. is in the process of acquiring ABC Inc. and the takeoverTakeoverA takeover is a transaction where the bidder company acquires the target company with or without the management's mutual agreement. Typically, a larger company expresses an interest to acquire a smaller company. Takeovers are frequent events in the current competitive business world disguised as friendly mergers.read more offer is $400 million in cash and $600 million in equity stock.

How to Calculate the Proration Factor?

Proration factor represents the proportion of shares that was accepted by the acquirer for the shareholders intending to participate in the offer. The proration factor can go up to 1, which indicates that the tender offerTender OfferA tender offer is a public proposal by an investor to all the current shareholders to purchase their shares. Such offers can be executed without the permission of the firm’s Board of Directors and the acquirer can coordinate with the shareholders for taking over the firm.read more is neither oversubscribed nor undersubscribed, and all the tender requests have been accepted in full.

Proration Formula

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Source: Proration (wallstreetmojo.com)

The calculation of the proration factor can be broken down into several steps, and they have been briefly discussed below:

Step #1: Firstly, determine what portion of the company’s outstanding shares would be part of the new corporate action, say share buybackShare BuybackShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.read more in this case. Let us assume that the company decided to buyback X% of its outstanding shares.

Step #2: Determine the proportion of the existing shareholders who intend to opt-out of the current corporate exercise as they are not interested in selling their equity stock at present. Let the proportion of shareholder who doesn’t wish to participate be represented by Y%.

Step #3: Calculate the proportion of the existing shareholders who wish to participate in the share buyback, and it is represented by (1 – Y%).

Step #4: If (1 – Y%) is less than equal X%, then there is no need for proration as all the interested shareholders will be able to participate. However, if (1 – Y%) is greater than X%, then the proration factor will come into play.

Step #5: Finally, the X% has to be proportionately distributed among the (1 – Y)% shareholders, and this is how the proration factor is calculated as shown below.

Proration factor = X% / (1 – Y%)

Practical Examples

Example #1

In January 2020, Winmark Corporation announced results of its share buyback offer. The company initially offered to purchase 300,000 shares from its existing shareholders at a purchase price of $163.00 per share, which in turn is an aggregate cost of ~$48.9 million (excluding fees and expenses related to tender offer). The depositary confirmed that 361,940 shares were tendered by the shareholders resulting in oversubscription.

As such, the company accepted all the payment request and distributed the payment for 300,000 shares among the interested shareholders on a pro-rata basis. Based on the number of shares tendered and proportion of the share accepted for payment, the proration factor for the tender offer can be calculated to 82.9% (= 300,000 / 361,940 * 100%).

Example #2

In August 2013, Halliburton accepted for purchase 68,041,236 shares of its outstanding common stock at a purchase price of $48.50 per share, which aggregated to approximately $3.3 billion (excluding fees and expenses related to tender offer). The company initially offered to purchase 300,000 shares from its existing shareholders at a purchase price of $163.00 per share, which in turn is an aggregate cost of ~$48.9 million (excluding fees and expenses related to tender offer).

While some of the lots were accepted in full and some others were automatically withdrawn. Nevertheless, the depository confirmed oversubscription and hence the shares were accepted on a pro-rata basis. Based on the number of shares tendered and proportion of the share accepted for payment, the proration factor for the tender offer was approximately 69.5%.

Is Proration Necessary

The proration mechanism ensures that all the shareholders of a company are treated equally (not favouring some investors over others). In contrast, the company can stick to its initial plan. Although in this process, the shareholders might not get what they initially selected, it ensures that all the shareholders get the same reward.

The proration technique is also useful in various other situations, such as bankruptcy, liquidation, stock splits, special dividends, spinoffs etc. These corporate actions are approved by the shareholders and are usually listed on a company’s proxy statementProxy StatementThe Securities and Exchange Commission (SEC) requires companies to present important information to their shareholders in the form of a proxy statement. It is required to be filed prior to each annual general meeting.read more or filed before the firm’s annual meeting.

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