How Does a Merger Affect Shareholders?

A merger happens when two companies combine to form a single entity. Public companies often merge with the declared goal of increasing shareholder value, by gaining market share or from entering new business segments. Unlike an acquisition, a merger can result in a brand new entity formed from the two merging firms.

A merger typically combines two companies of roughly equivalent size. The purchase of a company by a larger entity is often called an acquisition. Mergers often involve the exchange of shares rather than cash consideration. For example, in August 2017 Dow Chemical merged with polymers manufacturer DuPont to form DowDuPont (DWDP) by exchanging Dow and DuPont shares for those in the combined company.

Key Takeaways

  • A merger is an agreement between companies of comparable size to combine into a single entity. 
  • Companies often merge to boost shareholder value by entering new markets or gaining greater share in those where they already compete.
  • Mergers are more likely than acquisitions to involve stock-for-stock deals rather than cash buyouts.
  • Moves in the share prices of the companies announcing a merger depend on the exchange ratio used and any cash consideration offered, as well as traders' views about the deal and the likelihood it will be completed.
  • Companies agreeing to "mergers of equals" often specify how they will integrate their boards, management teams, and businesses if the deal goes through.

How Merger Announcements Affect Share Prices

The effect of a merger announcement on the share price will vary with the specifics of the deal as well as market perceptions of the transaction's value and the likelihood it will be completed.

If the merger is to be accomplished with an exchange of shares, the exchange ratio determines whether one of the companies is receiving a premium above its share price before the announcement in the deal. Shares of that company may rise, though that rise may be limited if the share price of its merger partner drops, eroding the initial premium.

To limit the risk of such erosion the terms of some mergers may include a collar agreement increasing the exchange ratio if a stock to be exchanged falls below a certain level. Such collars limit the downside for one company's shareholders at the expense of its merger partner and that company's shareholders, but are less common in mergers of equals or near-equals.

The market may also discount the proposed merger premium if the deal faces significant potential roadblocks, for instance in terms of regulatory approval. Conversely, shares of a company could trade above the proposed merger premium if investors believe the deal announcement may prompt higher bids from new suitors.

Example

The shares of both companies announcing a merger may rise if investors view the deal favorably and believe it's likely to be completed.

For instance, in February of 2022, Spirit Airlines (SAVE) and Frontier Airlines (ULCC) announced the two companies would merge in a deal valued at $6.6 billion. Under the terms of the agreement, Spirit shareholders will receive 1.9126 shares of Frontier and $2.13 in cash for each Spirit share they own. Following the announcement, shares of Spirit Airlines rose from around $20 to almost $28, a 40% jump. Frontier shares rose more modestly, from around $12.50 to $14.25 (almost 15%).

A merger of equals is the combination of companies of similar size on mutually beneficial terms in which neither party is considered an acquirer.

How Mergers Affect Corporate Governance

Whatever the exchange ratio in a stock-for-stock merger, shareholders of both companies will have a stake in the new one. Shareholders whose shares are not exchanged will find their control of the larger company diluted by the issuance of new shares to the other company's shareholders. Often, merger announcements will specify what percentage of the combined company each group of shareholders will own based on the deal's terms.

Companies negotiating a merger must also consider who will lead the combined company, and how their boards of directors, management teams, and businesses will be integrated.

Control of the combined company can be the motivation for a merger, and how it is apportioned can affect the deal's financial terms. In some cases, senior managers' compensation agreements can include change-of-control provisions paying them bonuses if the company is merged or acquired.

What Typically Happens to Company Stocks When Companies Merge?

When a company announces it will buy another, often the target company's share will rise (approaching the takeover price) while the acquiring company may see its share price dip somewhat to account for the cost of the purchase. If a merger is construed by the market to produce synergies that will benefit the acquirer and the target, both company's shares may rise. If the market feels the deal is a blunder, both share prices may even fall.

What Happens to the Price of a Stock When a Publicly Traded Company Merges With a Private Company?

If a publicly traded company is acquired by a private company, its share prices will typically rise to the takeover price. When the deal is closed, existing shareholders will receive cash in return for their stock (i.e., their shares will be sold to the acquiring company). If a public company takes over a private firm, the acquirer's share price may fall a bit to reflect the cost of the deal.

What Usually Happens to Stock in a Reverse Merger?

A reverse merger (or reverse IPO) is a way for private companies to go public by identifying an existing publicly-traded shell company to effectively buy the private firm. At that point, the managers of the target firm become the managers of the shell company itself and run the business. The price of that shell company's stock may rise if investors believe there is value in the new entity.

Article Sources

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  1. Dow. "DowDuPont Merger Successfully Completed."

  2. Frontier Airlines Inc. "Frontier Airlines and Spirit Airlines to Combine, Creating America’s Most Competitive Ultra-Low Fare Airline."

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