What is a Stock Swap?

The most commonly used definition for the term "stock swap" is the exchange of one equity-based asset for another associated with the circumstances of a merger or acquisition. A stock swap occurs when shareholders' ownership of the target company's shares are exchanged for shares of the acquiring company. During a stock swap, each company's shares must be accurately valued in order to determine a fair swap ratio.

Key Takeaways

  • Stock swaps trade shares of one company for shares of another.
  • This usually happens around a merger or acquisition.
  • Analysts work to determine a fair swap ratio based on the company valuations.
  • As a term, "Stock Swap" can also refer to something that happens with employees who exercise stock options.

How a Stock Swap Works

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.

Additional Meaning for Stock Swap

Another use of the term stock swap occurs in the less common circumstances of an employee who wants to exercise their stock options and turn them into shares. An employee who was a co-founder or early higher of a highly successful startup might find that they have the option to purchase many shares of the stock, but that the money required to purchase those shares is prohibitive. In such circumstances the employee may use the value of shares already owned to pay for the new shares. Rather than selling those shares to raise the cash to exercise the option, the employee merely swaps out the shares to pay for the exercise of many more shares.

Advantage and Disadvantages of an Option-Triggered 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 Tax liabilities. Any employee who faces this circumstance should seek out a qualified individual to help them validate the costs and benefits of the move. The stock swap is a complex transaction best accomplished with the help of an adviser.