How Do Stock Swaps Work?

Cash isn't the only currency. If you can get people to accept something as payment -- be it dollar bills, baseball cards, pine cones, whatever -- then it qualifies as currency. In business, shares of stock get used as currency all the time. Stock swaps allow you to use stock to buy entire companies, or even more shares of the same stock.

Stock Swap Acquisitions

Stock swaps allow one company to take over another without having to pay cash for the whole operation. Instead, it uses its own stock as currency. For example, say Consolidated Wastebasket Inc. wants to acquire a competitor, American Trashcan Corp., in a "stock-for-stock" swap. Consolidated gives American's stockholders a certain number of its own shares in exchange for each share of American stock they own. In a 2.5-for-1 exchange, for example, an American Trashcan stockholder with 50 shares would wind up with 125 shares of Consolidated. The American Trashcan stock is canceled, and American no longer exists as a separate company.

Setting the Ratio

A lot of work goes into determining the exact ratio of the stock swap. First, the parties involved have to calculate the value of each company. The difference in their share prices and the number of shares outstanding then have to be factored in, and the acquiring company may need to throw in a little extra to get the target company's board of directors and shareholders to play ball. The result might be a nice clean ratio, such as 2-for-1 or 1-for-3, or it can be a lot more finessed: In the 2010 merger of energy companies Mirant and RRI, for example, Mirant shareholders got 2.835 shares of RRI for each share they owned. That deal also helps illustrate an important point. A lot of deals billed as "mergers of equals" are really takeovers. If one company's shareholders are giving up their stock in a swap, it's a takeover.

Swap Options

An entirely different kind of financial transaction also goes by the name of "stock swaps." This strain of swap is a stock option. But unlike traditional stock options, which require you to pay cash for shares, stock swap options allow you to exchange shares you already own for a larger number of new shares. The swap allows you to exercise your option even if you don't have much cash available -- or you don't want to part with the cash you do have.

How Swap Options Work

Say you own 200 shares of stock in your employer, Consolidated Wastebasket. The current share price is $50, so your stock is worth $10,000. You hold an option to purchase 100 more shares at a bargain price of $20 a share, but you don't have the $2,000 you'd need to exercise the option. If your option allowed for swaps, you could trade in 40 of the Consolidated shares you already own -- which have a current market price of $2,000 -- and receive 100 new shares back. Your new holdings: 260 shares with a current market price of $13,000. You've exercised the option, and obtained the $30-per-share gain on the 100 shares in the option, but no cash changed hands.

About the Author

Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.