Share Swap Meaning
Share Swap is that it is a mechanism by which one equity-based asset is exchanged with another equity-based asset based on an exchange ratio under the circumstances of mergers, acquisitions, or takeovers.
How does Share Swap work?
During mergers and acquisitions, a firm pays for the acquisition of the target firm in the open market by issuing its shares to the shareholders of the target firm.
The new shares are issued based on a conversion mechanism based on the following vital parameters.
- The current market value of the target firm
- The current market value of the issuing firm
- The premium that the issuing firm wants to give to the target firm’s shares based on the growth prospects
- A predefined cut off date as the share price is a dynamic price that changes every moment in the market based on buyers’ and seller’s perception of the prevailing market price.
Share Swap Deal Example
Let’s consider the acquisitionAcquisitionAn acquisition is defined as the act of taking over or gaining control of all or most of another entity's stocks by purchasing at least fifty percent of the target company's stock and other corporate assets. read more of a major IT firm ABC. It has a significant market share in the US but a negligible presence in the European markets. The firm looks for inorganic growth and considers acquiring the firm XYZ, which has a good market presence in European markets. ABC can use its vast cash reserves to acquire XYZ or can get into a share swap deal by offering a deal to its shareholders in the open market.
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For eg:
Source: Share Swap (wallstreetmojo.com)
But before finalizing the deal, the firm has to take care of specific parameters like current market value, current share price, and the cut-off date. Consider the following data. All prices are in pounds.
- Cut Off Date: 1-Aug-2019
- Current Share Price (XYZ): 100
- Current Share Price (ABC): 1,000
- Total Market Value (XYZ) : 1,000,000
- Total Outstanding Shares: 10,000
- Share Value Offered: 125
- Total Value of the Deal: 1,250,000
- Premium Charged: 250,000
- Premium Calculated per Share: 25
- Share Swap: 8
As mentioned earlier, the firm has two options for the shareholders of the target firm. They can either shed their shares in the open market for $125 at a premium of $25. The second option is that the shareholders can swap their shares in the ratio of 1:8.
Advantages
- The Biggest advantage of the share swap is that it limits the cash transactions. Even the cash-rich companies find it challenging to set aside a large pile of cash to carry out the transactions for mergers and acquisitions. Hence a no-cash deal mechanism of share swap helps the firms eliminating the need to carry out the cash-based transactions. It helps them, in turn, saving borrowing costs and also eliminating any opportunity costsOpportunity CostsThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven.read more. For cash strapped firms, it is a boon as it helps them utilize the current market value of their assets to carry out such deals.
- Share swap mechanism attracts less tax liability, and the newly formed firm can save itself from regulators scrutiny who are often watching these deals very closely. Sometimes, the new firm structure is much less tax liable, helping the acquiring firm benefit from low taxes. An essential factor in this regard is that such a deal is only an exchange of equity. So technically, regulators can’t classify them as tax liable transactions.
- In accounting terms, the firm with its new structure can benefit from the goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price.read more created. It can benefit from the government policies as it will employ more people now, it can command a better premium from its clients. It can negotiate better with the suppliers because of increased market share.
Disadvantages
- There is an exchange of equity in share swap – aka cashless transactions. When equity exchange hands, promotors, owners, or large shareholders might have to dilute their holding, leading to dilution of power in the newly formed entity structure.
- Due to the exchange of equity, the stakeholders have less hold on the company. It could lead to fewer profits for the shareholders. For management, it can lead to more delays in executing decisions as there are new parties whose consent has become all the more important now. In fact, in specific scenarios, the newly formed firm structure can itself become prone to hostile takeovers and acquisitions.
Limitations
- By helping in hostile takeovers, a share swap can be a nightmare for the management of the target firm. They can be acquired anytime if they hold on to the firm’s management. Thus, economists often criticize share swap for being capitalist friendly and favoring the rich.
- Share swap has an inherent synergy risk. What if the newly created entity is too big to sustain or eating into each other’s market share or leading to discontent among the workforce due to contrasting work cultures. Such a scenario can lead to disastrous results.
Important points to note
- The share swap deal has the biggest application in the mergers and acquisitions framework. It helps your assets (equity) buy the target firm using equity as a currency, eliminating any cost of carrying or risk of cash-based transactions.
- The mechanism works in a way that the acquiring company provides a deal to the shareholders of the target firm to shed their shares in exchange for new shares issued by the acquirer firm.
- Most often than not, it is a very advantageous position for the shareholders of the target firm as they get a premium. For the acquirer firm’s shareholders, it leads to dilution of the intrinsic value of the share in the short term.
- Most often ignored but equally, the most important one is the synergy risk that is inherentRisk That Is InherentInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization.read more in the share swap deal. It is shared by the shareholders of both firms.
Conclusion
For cash-rich companies, share swap can be a mechanism for hostile takeovers for the target firms, which are attractive because of their profit-making ability and forecasted growth opportunities, but their management is not keen on expanding the business. Shareholders of such firms will be more than interested in selling their shares to the buyer firm in the open market. Thus, share swap provides a farfetched mechanism to change the risk-averse management with growth-oriented, aggressive, and market-friendly management.
Recommended Articles
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