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What is a stock-for-stock merger and how does this corporate action affect existing shareholders?
First, let's be clear about what we mean by a stock-for-stock merger. When a merger or acquisition is conducted, there are various ways the acquiring company can pay for the assets it will receive. The acquirer can pay cash outright for all the equity shares of the target company, paying each shareholder a specified amount for each share. Or, it can provide its own shares to the target company's shareholders according to a specified conversion ratio (i.e. for each share of the target company owned by a shareholder, the shareholder will receive X number of shares of the acquiring company). Acquisitions can be made with a mixture of cash and stock, or with all stock compensation, which is called a "stock-for-stock" merger. (To learn more, see What does the term "stock-for-stock" mean?)
When the merger is stock-for-stock, the acquiring company simply proposes to the target firm a payment of a certain number of its equity shares in exchange for all of the target company's shares. Provided the target company accepts the offer (which includes a specified conversion ratio), the acquiring company essentially issues certificates to the target firm's shareholders, entitling them to trade in their current shares for rights to acquire a pro-rata number of the acquiring firm's shares. The acquiring firm basically issues new shares (adding to its total number of shares outstanding) to provide shares for all the target firm's shares that are being converted.
This action, of course, causes the dilution of the current shareholders' equity, since there are now more total shares outstanding for the same company. However, at the same time, the acquiring company obtains all of the assets and liabilities of the target firm, thus approximately neutralizing the effects of the dilution. Should the merger prove beneficial and provide sufficient synergy, the current shareholders will gain in the long run from the additional appreciation provided by the assets of the target company.