Share Swap Meaning
Meaning of 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 own shares to the shareholders of the target firm.
The new shares are issued based on a conversion mechanism which is based on the following important parameters.
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- The current market value of the target firm
- The current market value of the issuing firm
- The premium that 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 acquisition of a major IT firm ABC. It has a big 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 huge cash reserves to acquire XYZ or can get into share swap deal by offering a deal to its shareholders in the open market.
But before finalizing the deal, the firm has to take care of certain parameters like current market value, current share price, and the cut-off date. Consider the following table. All prices are in pounds.
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 difficult 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. This helps them, in turn, saving borrowing costs and also eliminating any opportunity costs. For cash strapped firms, it is a boon as it helps them in utilizing 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. In fact, sometimes the new firm structure is much less tax liable helping the acquiring firm to benefit from low taxes. An important 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 goodwill created. It can benefit from the govt. policies as it will employ more people now, it can command a better premium from its clients and 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.
- As mentioned earlier, due to the exchange of equity the stakeholders have less hold on the company. This 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 certain 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 eases on 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) to buy the target firm using equity as a currency eliminating any cost of carry 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 inherent in the share swap deal. This 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 to sell their shares to the buyer firm in the open market. Thus, share swap provides a farfetched mechanism to change the risk-averse management with a growth-oriented, aggressive and market-friendly management.
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