Stock Swap: Definition, How It Works, Example, and Taxation

What Is a Stock Swap?

A stock swap is the exchange of one equity-based asset for another and is often associated with the payment for a merger or acquisition. A stock swap occurs when shareholders' ownership of the target company's shares is 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 between the two shares.  A set number of shares of one company are swapped with the shares of another as a way of covering costs.

Stock swaps also occur in employee stock compensation programs (ESOPs), in which employees exchange stock that has already vested so as to receive more stock options.

Note that a stock swap should not be confused with an equity swap, which is similar to an interest rate swap but rather than one leg being the "fixed" side, it is based on the return of an equity index.

How a Stock Swap Works

Stock swaps can constitute the entirety of the consideration paid in a merger and acquisition (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.

Also known as a stock-for-stock deal, an acquiring company's stock is exchanged for the stock of the acquired company at a predetermined rate. Usually, only a portion of a merger is completed with a stock-for-stock transaction, with the rest of the expenses being covered with cash or other payment methods.

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.

Employee Compensation Stock Swaps

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 buyer 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. An employee in this situation 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.

Special Considerations

When an executive is granted either an incentive stock option (ISO) or a non-qualified stock option (NSO), that employee must actually obtain the shares that underlie the option in order to make the option have any value.

Both NSOs and ISOs are typically granted under the condition that the executive is forbidden from selling them or giving them away because they are mandated to exchange the options for stock. These terms are written into an executive’s contract.