Swap Ratio: What it is, How it Works, Special Considerations

What Is a Swap Ratio?

A swap ratio is a ratio at which an acquiring company will offer its own shares in exchange for the target company's shares during a merger or acquisition. When two companies merge or when one company acquires another, the transaction does not have to be an outright purchase of the target company's shares with cash. It can involve a stock conversion, which is basically an exchange rate, described through the swap ratio.

Understanding a Swap Ratio

A swap ratio tells the shareholders of a target company how many shares of the acquiring company's stock they will receive for every one share of target company stock they currently own. For example, if an acquiring company offers a swap ratio of 2:1, it will provide two shares of its own company for every one share of the target company.

A shareholder of the target company will end up with more shares than they had before, but their new shares will be for the acquiring company and have the price of the acquiring company. Shares of the target company may cease to exist.

To arrive at the appropriate swap ratio, companies analyze a variety of financial and strategic metrics, such as book value, earnings per share (EPS), margins, dividends, and debt levels. Other factors play into the swap ratio as well, such as the growth of each entity and the reasons for the merger or acquisition. The swap ratio is a financial metric but it is not calculated based solely on financial analysis, negotiations and other strategic considerations factor into the final number.

The current market prices of the target and acquiring company's stocks are compared along with their respective financial situations. A ratio is then configured that states the rate at which the target company's shareholders will receive the acquiring company's shares of stock for every one share of target company stock they currently hold.

Swap ratios are important because they aim to ensure that the shareholders of the companies are not impacted by the merger or acquisition and that the shareholders maintain the same value as they did before, with the hopes of further growth through the synergies of a merged company.

Special Considerations

The concept of a swap ratio can also be applied to a debt/equity swap. A debt/equity swap occurs when a company wants investors to trade their bonds issued by the target company for the acquiring company's shares of stock. The same process is applied and a swap ratio is given that tells the target company's bond investors how many shares of stock of the acquiring company they will receive for each bond they trade in.