Proration

Key Takeaways

• Proration occurs when cash or shares are insufficient to meet shareholder offers during a corporate action, ensuring equitable distribution.
• It typically arises in mergers and acquisitions, stock splits, and special dividends when firms can't meet shareholder cash/equity preferences.
• Proration distinguishes itself from pro-rata, which entails a proportional payment allocation, not influenced by shareholder choice.
• The process ensures no favoritism among investors; everyone receives a fair value, despite differing initial requests for cash or equity.
• Shareholders may prefer different compensation forms for various financial objectives, such as tax optimization or growth potential.

What Is Proration?

Proration occurs during corporate actions like acquisitions when a company must allocate limited cash or shares among shareholders fairly. In scenarios where shareholders have preferences for cash or equity in a deal, proration ensures that they receive a balanced distribution based on the company's resources.

Understanding proration helps investors know what to expect when company resources are limited and how it affects their financial interests. We'll explain how it functions and provide examples to clarify its use during mergers, acquisitions, and other corporate events.

Proration should not be confused with pro-rata, which indicates some proportional allocation or distribution.

How Proration Ensures Fair Distribution in Corporate Actions

Proration supports shareholders by ensuring that a company holds to its initial target and does not favor some investors over others (e.g., giving a percentage of shareholders the cash they wanted while delivering shares to the rest). While this means that every investor might not receive their initial election, it ensures that all receive the same value.

Other situations in which the need for proration might occur include bankruptcy or liquidation, special dividends, stock splits, and spinoffs.

Tip

While these corporate actions must be approved by shareholders, and a company will typically list them on a firm's proxy statement in advance of its annual meeting, shareholders must occasionally sacrifice to maximize wealth for all shareholders.

Considerations for Proration in Mergers and Acquisitions

Mergers occur for several reasons, including to gain market share through a horizontal merger, reduce the costs of operations through a vertical merger, expand to new markets, or unite common products through a congeneric merger. After a merger, shares of the new company are distributed to existing shareholders of both original businesses.

When deciding to merge, in addition to how both companies will reward shareholders, it is important to take into consideration the Federal Trade Commission’s guidelines on keeping the industry competitive and avoiding the creation of monopolies.

Important

It is important to ask whether a proposed merger will create or enhance market power or not. An antitrust concern arises particularly with proposed horizontal mergers between direct competitors.

Real-World Example of Proration

Suppose a company decides to acquire a rival for $100 million, which consists of 75% cash and 25% equity. The cash-equity split might undergo a revision if a majority of investors of the company being acquired elect to be paid in cash.

In that case, the acquiring company will change its accounting figures in order to accommodate the demand for cash. This will result in each investor of the acquired company receiving less cash than originally planned. A firm, for example, may have to revise an original offer to buy back stock and reduce it by a factor of, say two-thirds, in order to balance investor demand and its stock price at that time.

What Is a Proporation Factor?

The proration factor refers to the fraction of equity shares accepted by an acquiring company needed for the target company's shareholders to participate in a takeover offer.

Proration factor may also refer to the amount of pension eligibility a plan participant is entitled to.

Why Does Proration Happen?

Proration can occur if a corporate action is planned, but there is not enough cash available to complete the transaction. Instead, equity shares are used as a form of payment, either in full or in part.

What Is Proration in Accounting?

In business accounting, proration can refer to the logical allocation of over- and under-utilized resources (e.g., finished inventories vs. works-in-progress) that a firm has in order to settle the books at the end of an accounting period.

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