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A merger is defined as an agreement between two existing companies to unite into a single combined entity. Companies engage in this activity to create shareholder value by increasing market share or by foraying into new business segments. For example, in August 2017, Dow Chemical, the mega-maker of plastics, chemicals, and agricultural products, famously merged with polymer manufacturer DuPont, to create DowDuPont (DWDP), which instantly became the world’s largest chemical company in terms of sales.
Key Takeaways
- A merger is an agreement between two existing companies to unite into a single entity.
- Companies often merge as part of a strategic effort to boost shareholder value by delving into new business lines and/or capturing greater market share.
- The pre-merger activity invariably impacts the share prices of the underlying companies. Specifically, the price of the acquiring firm usually experiences a temporary drop in value, while the share price of the target firm typically spikes.
- Post-merger, the combined entity of the newly-formed entity typically exceeds the value of each company during its pre-merge stage.
- Shareholders of the merged company usually experience enviable long-term performance and strong dividends.
How Stock Price Is Affected
In the days leading up to a merger, the share price of both underlying companies are differently impacted, based on a host of factors, such as macroeconomic conditions, market capitalizations, as well as the execution of the merger process itself. But generally speaking, shareholders of the acquiring firm usually experience a temporary drop in share value. In contrast, shareholders in the target firm typically observe a rise in share value during the same pre-merge period, mainly due to stock price arbitrage, which describes the action of trading stocks that are subject to takeovers or mergers. Simply put: the spike in trading volume tends to inflate share prices.
After a merge officially takes effect, the stock price of the newly-formed entity usually exceeds the value of each underlying company during its pre-merge stage. In the absence of unfavorable economic conditions, shareholders of the merged company usually experience favorable long-term performance and dividends.
Shareholder Voting Power and Dilution
The shareholders of both companies may experience a dilution of voting power due to the increased number of shares released during the merger process. This phenomenon is prominent in stock-for-stock mergers, when the new company offers its shares in exchange for shares in the target company, at an agreed-upon conversion rate.
Shareholders of the acquiring company experience a marginal loss of voting power, while shareholders of a smaller target company may see a significant erosion of their voting powers in the relatively larger pool of stakeholders.
Changes in Management
After a merger is complete, the new company will likely undergo certain noticeable leadership changes. Concessions are usually made during merger negotiations, and a shuffling of executives and board members in the new company often results.
A deal may be known as a “merger of equals” if both companies benefit to the same degree, and willingly enter into the arrangement.