Stock Swap: Understand Definition, Process, Examples, and Tax Impact

What Is a Stock Swap?

A stock swap is the exchange of one company’s shares for another’s. Stock swaps are often used in mergers or acquisitions. They are also commonly part of employee compensation plans. They involve determining a fair swap ratio based on each company’s valuation to ensure both sides receive equal value. Stock swaps allow companies to complete deals without using cash and give employees ownership stakes. Because there are tax implications, financial advisors play an important role in helping participants understand and manage their tax obligations.

Understanding the Mechanics of Stock Swaps

Stock swaps can cover all, part of the M&A deal, or be calculated for both acquirer and target in a new entity.

In a stock-for-stock deal, the acquiring company's stock is swapped for the acquired company's stock at a set 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.

Real-World Stock Swap Example

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.

In an all-stock deal, the target company's stock price will fluctuate with the agreed swap ratio.

For target company shareholders, the IRS does not see the original investment as a "disposal" during a takeover. 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.

Stock Swaps in Employee Compensation Plans

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.

Pros and Cons of Stock Swaps for Employee Options

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.

Important Considerations for Executives

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.

Executives can't sell or give away NSOs and ISOs because they're meant to be exchanged for stock. These terms are written into an executive’s contract.

The Bottom Line

Stock swaps are mainly used in mergers, acquisitions, and employee compensation programs, allowing one company’s shares to be exchanged for another’s. It involves determining a fair swap ratio, which ensures an accurate equity exchange between parties. In all-stock deals, shareholders typically don’t face immediate taxes, as the IRS defers taxation and preserves the original cost basis of the investment. However, employee stock swaps can trigger certain tax liabilities, such as the alternative minimum tax. Because these transactions can be complex, it's important to consult a financial professional to understand the tax and financial implications.