What it means
In a stock-for-stock deal, the buyer issues new shares and hands them to the target's shareholders in exchange for their existing holdings. The target becomes a subsidiary, or is merged into the buyer, and the former owners become shareholders of the combined group.
They therefore share in any future success or failure. The price the target receives is not fixed in dollars unless the deal is structured that way.
If the exchange ratio is fixed, the value of the offer moves every day with the buyer's share price. This means the premium the target's shareholders think they are getting at signing can grow or shrink before closing.
Buyers prefer this structure when cash is scarce, when borrowing would be expensive or when they consider their own shares well valued. Targets may accept because the exchange can, in many countries, be taxed more lightly than a cash sale, subject to detailed local rules.
They also keep exposure to the upside of the combined business. The costs fall on the buyer's existing shareholders, who are diluted.
A buyer should ask whether the acquired profits and savings justify issuing the shares, usually by looking at earnings per share before and after the deal. A deal that lowers earnings per share is described as dilutive.
Securities rules also apply. Because new shares are being offered to the public or to many holders, the buyer typically needs approval from its own shareholders and must produce a detailed disclosure document.
This makes stock-for-stock deals slower and more regulated than simple cash purchases. The accounting is also more involved than in a cash purchase.
The buyer measures the shares it issues at their fair value on the closing date and compares that with the fair value of the net assets acquired. Any excess is recorded as goodwill, which must be tested for impairment (a fall in value) in later years.
In practice
Real-world examples.
Example
A listed pharmaceutical company with a strong share price acquires a smaller research firm. It pays 0.5 of its shares for each research-firm share and keeps its cash for clinical trials. The research firm's owners become shareholders in the larger company.
Example
Two regional insurers combine in a stock-for-stock merger, and each group's shareholders receive shares in the new parent. Neither company has to borrow to complete the deal. The new parent's board comes from both firms.
Example
A private software founder sells to a listed company for shares worth $8,000,000 at the signing date. The shares are subject to a lock-up, which means he cannot sell them for a year. Over that period the price falls 10%, so his shares are worth about $7,200,000 when the lock-up ends.
Formula
Calculation
Implied offer value per target share = exchange ratio x buyer's share price
Premium = (implied offer value - target's share price) / target's share price
A buyer offers 0.8 of its shares for each target share. The buyer's shares trade at $25 and the target's at $18. Implied offer = 0.8 x 25 = $20. Premium = (20 - 18) / 18 = 2 / 18 = 11.1%. If the buyer's price falls to $22 before closing, the implied offer = 0.8 x 22 = $17.60, which is below $18, so the premium has turned into a discount.Case study
Seen in the real world.
Ironbridge Components is an illustrative, fictional listed company whose shares trade at $32. It wants to buy Delta Fabrication, a private competitor valued by both sides at $64,000,000, but it has only $5,000,000 of cash and does not want more debt.
The two sides agree a stock-for-stock deal, so Ironbridge issues 64,000,000 / 32 = 2,000,000 shares to Delta's owners. Ironbridge had 18,000,000 shares before the deal, so Delta's owners hold 2,000,000 / 20,000,000 = 10% of the combined company.
Ironbridge's finance director shows that the added profit from Delta will raise earnings per share within two years, so the issue of shares is not dilutive for long. The illustrative lesson is that paying in shares conserves cash but only makes sense if the acquired earnings justify the extra shares.
Watch out
Common mistakes.
- Assuming the headline price is fixed, when with a fixed exchange ratio the value moves with the buyer's share price.
- Ignoring dilution, when issuing many new shares can reduce earnings per share for existing owners.
- Thinking sellers receive cash, when they receive shares that they may be restricted from selling for a time.
Questions
People also ask.
What is a stock-for-stock merger?
It is a merger in which the buyer pays for the target entirely with its own shares, and the target's owners receive shares at an agreed exchange ratio.
Is a stock-for-stock deal taxable?
In many countries, it can be tax-deferred for sellers if specific conditions are met, but the rules vary and change, so professional advice is essential.
How is it different from a cash deal?
In a cash deal the sellers receive a fixed amount and leave, while in a stock-for-stock deal they stay as part-owners and bear the risk of the buyer's share price.
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