What it means
The central term in a stock swap is the exchange ratio, which states how many shares of the buyer are given for each share of the target. If the ratio is 1.5, a holder of 100 target shares receives 150 buyer shares.
The ratio is set by dividing the offer price per target share by the buyer's share price. The buyer uses stock when it lacks cash, wants to preserve its borrowing capacity or believes its own shares are richly valued.
The target's owners may accept because they share in future gains and, in many countries, can defer tax on the exchange under conditions set by local law. For the sellers, the risk is that the value of what they receive moves with the buyer's share price.
New shares mean dilution, so the buyer's existing shareholders own a smaller slice of a larger company. The question is whether the target adds enough profit and growth to make that smaller slice worth more.
Boards compare the price paid, in shares, with the earnings and cash flow acquired. Deals can be structured in different ways.
In a fixed exchange ratio, the number of shares is set at signing, so the value delivered changes with the buyer's price until completion. In a fixed value structure, the number of shares adjusts so that the sellers receive a set dollar amount, which protects the sellers but exposes the buyer to dilution if its price falls.
Many deals mix cash and shares. Mixed consideration lets the buyer limit dilution while still giving sellers some immediate cash.
Accounting for the deal follows the acquisition method, in which the buyer records the purchased assets and liabilities at fair value.
In practice
Real-world examples.
Example
A software company with a high share price buys a smaller rival without using any of its cash reserves. It offers 0.8 of its own shares for each rival share. The rival's owners become shareholders in the larger business and benefit if the combination succeeds.
Example
Two regional banks of similar size agree a merger of equals by exchanging shares at a fixed ratio. The shareholders of each bank end up owning about half of the new group. No cash changes hands, so the banks keep their capital intact.
Example
A founder sells her logistics start-up to a listed competitor in return for shares worth $10,000,000. She agrees not to sell them for 12 months. During that period, her wealth rises and falls with the buyer's share price.
Formula
Calculation
Exchange ratio = offer price per target share / buyer's share price
New shares issued = target shares outstanding x exchange ratio
A buyer's shares trade at $40 and it offers $60 for each target share. Exchange ratio = 60 / 40 = 1.5. The target has 2,000,000 shares, so new shares issued = 2,000,000 x 1.5 = 3,000,000. Deal value = 3,000,000 x 40 = $120,000,000, which equals 2,000,000 x 60. The buyer has 12,000,000 shares before the deal, so target holders own 3,000,000 / 15,000,000 = 20% of the combined company.Case study
Seen in the real world.
Northgate Devices is an illustrative, fictional listed company with 20,000,000 shares trading at $50. It agrees to acquire a smaller supplier, Cobalt Sensors, with 3,000,000 shares, at an offer of $75 per Cobalt share.
The exchange ratio is 75 / 50 = 1.5, so Northgate issues 3,000,000 x 1.5 = 4,500,000 new shares. The deal is worth 4,500,000 x 50 = $225,000,000, and Cobalt's holders end up with 4,500,000 / 24,500,000 = about 18.4% of the combined company.
Between signing and closing, Northgate's share price falls to $45, so the sellers now receive shares worth only 1.5 x 45 = $67.50 per share. The illustrative lesson is that in a fixed-ratio swap, the sellers carry the price risk, and negotiating a collar (a range limiting the swing) may be sensible.
Watch out
Common mistakes.
- Treating shares issued as free money, when they dilute existing owners and carry a real cost.
- Quoting the deal value at signing and forgetting that it moves with the buyer's share price until completion.
- Ignoring tax and regulatory conditions, which differ by country and can change the economics for sellers.
Questions
People also ask.
What is an exchange ratio?
It is the number of buyer shares given for each target share, calculated by dividing the offer price per target share by the buyer's share price.
Why would a company pay in shares rather than cash?
It may lack cash, want to keep its borrowing capacity or think its own shares are highly valued, and it also shares risk with the sellers.
Is a stock swap the same as stock-for-stock?
In most uses they mean the same thing, an acquisition paid for with the buyer's shares, although stock swap can also mean any exchange of one holding for another.
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