Share Swap Meaning Example How Does A Share Swap Work In M A

During mergers and acquisitions, a firm pays for the acquisition of the target firm in the open market by issuing its shares to the target firm’s shareholders.

The new shares are issued based on the following vital parameters: a conversion mechanism.

The current market value of the target firmThe current market value of the issuing firmThe premium that the issuing firm wants to give to the target firm’s shares based on the growth prospectsA predefined cut-off date as the share price is a dynamic price that changes every moment in the market based on buyers’ and sellers’ perceptions of the prevailing market price.

Let’s consider the acquisitionAcquisitionAcquisition refers to the strategic move of one company buying another company by acquiring major stakes of the firm. Usually, companies acquire an existing business to share its customer base, operations and market presence. It is one of the popular ways of business expansion.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. So the firm looks for inorganic growth and considers acquiring XYZ, which has a good market presence in European markets. ABC can use its vast cash reserves to acquire XYZ or get into a share swap deal by offering a deal to its shareholders in the open market.

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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-2019Current Share Price (XYZ): 100Current Share Price (ABC): 1,000Total Market Value (XYZ) : 1,000,000Total Outstanding Shares: 10,000Share Value Offered: 125Total Value of the Deal: 1,250,000Premium Charged: 250,000Premium Calculated per Share: 25Share Swap: 8

As mentioned earlier, the firm has two options for the target firm’s shareholders. First, they can 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 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 eliminate the need to carry out cash-based transactions. It helps them, in turn, save borrowing costs and eliminates 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 equity exchange. 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 exchanges 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 equity exchange, 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 become prone to hostile takeoversHostile TakeoversA hostile takeover is a process where a company acquires another company against the will of its management.read more and acquisitions.

Limitations

Important points to note

The share swap deal has the biggest application in the mergers and acquisitionsMergers And AcquisitionsMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion.read more 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 so 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 target firm’s shareholders as they get a premium. For the acquirer firm’s shareholders, it dilutes the intrinsic value of the share in the short term.Most often ignored but equally, the most important one is the synergy risk inherentRisk 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. The shareholders of both firms share it.

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. Still, 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.