Stock Swap

What is a 'Stock Swap'

A stock swap is the exchange of one equity-based asset for another. Two applications are business combinations and equity compensation for employees of a company.

1. A stock swap occurs when shareholders' ownership of the target company's shares are exchanged for shares of the acquiring company as part of a merger or acquisition. During a stock swap, each company's shares must be accurately valued in order to determine a fair swap ratio.

2. A stock swap can also occur when a stock option is exercised by an employee and uses shares already owned to pay for the new shares.

BREAKING DOWN 'Stock Swap'

Stock swaps can constitute the entirety of the consideration paid in an M&A deal; they can be a portion of an M&A deal along with a cash payment to shareholders of the target firm; or they can be calculated for both acquirer and target for a newly-formed entity, as in the following:

Example of a Stock Swap

In 2017 The Dow Chemical Company ("Dow") and E.I. du Pont de Nemours & Company ("DuPont") closed a merger where Dow shareholders received a swap ratio of 1.00 share of DowDuPont (the combined entity) for each Dow share, and DuPont shareholders received a swap ratio of 1.282 shares of DowDuPont for each DuPont share. 

Note that in the case of an all-stock deal, after the swap ratio terms have been agreed upon, the stock price of the target company will fluctuate in value roughly according to the stock swap ratio. Also, for the shareholders of the target company, the IRS does not consider the original investment as a "disposal" for tax purposes when the company is taken over. No gain or loss needs to be reported at deal closing. The cost basis for shareholders of the merged company will be the same as the original investment.

Advantage and Disadvantage of a Stock Swap

A typical stock swap transaction for an employee of a company who is partially compensated with stock entails the exchange of stock already owned outright with new shares from the exercise of stock options. Essentially, the employee exchanges existing shares for a new set of shares at an exchange ratio. The main advantage of this swap is that the employee does not have to use cash to receive the new set of shares; the drawback is that the swap may trigger AMT liability. The stock swap is a complex transaction best handled by an adviser.