When a merger or acquisition is conducted, there are various ways the acquiring company can pay for the assets it will receive. The acquirer can pay cash outright for all the equity shares of the target company — paying each shareholder a specified amount for each share. Or, it can provide its own shares to the target company's shareholders according to a specified conversion ratio — so for each share of the target company owned by a shareholder, the shareholder will receive X number of shares of the acquiring company. Acquisitions can be made with a mixture of cash and stock, or with all stock compensation — which is called a stock-for-stock merger.

What is a Stock-for-Stock Merger?

As mentioned above, a stock-for-stock merger can take place during the merger or acquisition process.

For example, Company A and Company E form an agreement to undergo a 1-for-2 stock merger. Company E's shareholders will receive one share of Company A for every two shares they currently own in the process. Company E shares will stop trading, and the outstanding shares of Company A will increase after the merger has gone through. But after the merger is complete, the share price of Company A depends on the market's assessment of the future earnings prospects for the newly merged entity.

One important point to note is that it is fairly uncommon for a stock-for-stock merger to take place in full. Usually, a portion of the transaction can be completed through a stock-for-stock merger, while the rest is done through cash and other equivalents. (To learn more, see What does the term "stock-for-stock" mean?)

Stock-for-Stock Merger and Shareholders

When the merger is stock-for-stock, the acquiring company simply proposes a payment of a certain number of its equity shares to the target firm in exchange for all of the target company's shares. Provided the target company accepts the offer (which includes a specified conversion ratio), the acquiring company essentially issues certificates to the target firm's shareholders, entitling them to trade in their current shares for rights to acquire a pro rata number of the acquiring firm's shares. The acquiring firm basically issues new shares (adding to its total number of shares outstanding) to provide shares for all the target firm's shares that are being converted.

This action, of course, causes the dilution of the current shareholders' equity, since there are now more total shares outstanding for the same company. However, at the same time, the acquiring company obtains all of the assets and liabilities of the target firm, thus approximately neutralizing the effects of the dilution. Should the merger prove beneficial and provide sufficient synergy, the current shareholders will gain in the long run from the additional appreciation provided by the assets of the target company. (To learn more about corporate mergers, check out The Wacky World of M&As and The Basics Of Mergers And Acquisitions.)

Why do a Stock-for-Stock Merger?

One of the reasons why companies may undergo a stock-for-stock merger is for efficiency. It's believed that this kind of transaction is far more efficient than traditional cash-for-stock mergers. That's because costs associated with the merger are well below traditional mergers.

Additionally, a stock-for-stock transaction doesn't impact the cash position of the acquiring company any further, so there's no need to go back to the market to raise more capital. Taking over a company can cost a lot of money — and the acquirer may have to issue short-term notes or preferred shares if it doesn't have enough, and that can affect its bottom line. Going through a stock-for-stock merger prevents a company from having to take those steps, saving it both time and money.

The Bottom Line

A stock-for-stock merger happens when shares of one company are traded for another during an acquisition. When, and if, the transaction is approved, shareholders can trade the shares of the target company for shares in the acquiring firm's company. These transactions — which are typically executed as a combination of shares and cash — are cheaper and more efficient, as the acquiring company doesn't have to raise more capital for the transaction.