Key Takeaways

  • The outcome of a stock in a merger depends on the type of transaction, deal terms, and a company's financial health.
  • Target company stocks often rise as acquiring companies usually offer a premium, incentivizing shareholders to approve the merger.
  • Acquiring company stock might drop due to the costs and risks associated with the merger, especially if investors perceive the merger as too costly or strategically unsound.
  • Announcements and rumors about mergers can lead to significant stock price fluctuations for both target and acquiring companies.
  • The acquiring company's issuance of new stock can dilute the stock's value, impacting both existing and new shareholders.
  • Post a job on UpCounsel to find a securities lawyer to help you navigate the complexities of mergers, stock transactions, and buyouts.

When two companies merge, what happens to stock? Many investors and shareholders ask this question when they hear news of mergers and acquisitions. 

The answer is not always straightforward. it will depend on factors such as the type of transaction, the terms of the deal, and the company's financial health.

This article will explore these factors in detail, explaining the process's intricacies, the pros and cons of mergers, and other vital information. 

What Happens to Stock When Companies Merge?

The nature of the acquisition will determine what happens to stock when companies merge. 

In some cases, the acquiring company can pay stock to the target company's controlling shareholders. 

If they pay cash, the acquiring company receives the stock that has been sold. Typically, the target company then becomes the subsidiary of the acquiring company. 

Impact on Target Company’s Stock

Acquiring companies often pay a premium above the current market value to incentivize the target company's shareholders to approve the deal. This higher cost reflects the acquiring company’s belief in the strategic value or synergies the acquisition will bring.  

As news of the acquisition or potential buyout spreads, investors anticipate this premium, often driving the stock price higher. 

In a hostile takeover, the acquiring company may try to purchase the target company without the approval of its management. Often, this results in uncertainty and potential disruption.  

This could cause the target company's stock to fall as investors worry about the outcome and future stability.  

Further, if the target company faces financial difficulties, including debt issues or declining profitability, the stock may drop as these uncertainties make the acquisition less attractive, lowering investor confidence.

Impact on Acquiring Company’s Stock

When a target company becomes a subsidiary of an acquiring company, there could be a cash sale. Then, the acquiring company can use its stock to acquire the target company's stock.  

Part of the deal would include an agreement on the valuation of the acquiring company versus that of the target company. This would determine how much of the buyer's stock the target company's shareholders would receive. 

Often, approval is required from the boards of the acquiring company and the target. 

An acquiring company using its stock to buy the other company is called either a stock-for-stock exchange or a share exchange tender offer.

Pre-Merger Volatility of Stocks

Rumors and announcements of mergers often influence stock prices and volatility. It’s not uncommon for a target's stock to run up when rumors of a merger first surface, and investors expect to make money if the acquirer offers a premium. 

Meanwhile, the acquirer's stock can drop due to the costs and risks surrounding the merger. 

These effects can intensify once a merger is announced: the acquirer’s stock might drop even more, while the target’s sometimes soars.

If the premium is large enough, the target company’s stockholders who are betting on the merger deal's success might reap huge rewards. 

Alternatively, they could also lose money if the merger fails, pushing the target company’s stock price back down to pre-rumor levels. 

The acquiring company's stockholders could also have their stock value lowered if the market believes the merger is too costly or strategically undesirable.

Examples: Stock Price Fluctuations and Mergers

Consider the merger of AT&T and Time Warner. 

In 2018, Time Warner’s stock soared at the news of the pending purchase that would command a premium from AT&T, reflecting shareholder enthusiasm about the buyout. 

In contrast, AT&T stock sank as investors weighed the potential windfall against the billions of dollars of financial obligations, regulatory challenges, and the resulting uncertainty of the deal. 

In 2016, we saw the failed merger of Pfizer and Allergan, which would have had immense financial implications and created the world’s largest drug firm. 

Instead, unfavorable rules proposed by the U.S. Department of Treasury eventually scuttled the deal, and Allergan’s stock tanked at its termination, highlighting the risk of making pre-merger investments.

What Happens to Stock in Different Types of Mergers?

As previously mentioned, the type of transaction or merger will influence a stock's fate. 

Below, we’ll discuss what happens to stock when a public company merges with a private company and during a reverse merger. 

Public Company Merging with Private Company

When a public company takes over a private company target, the target company (the private entity) usually sees its perceived value increase. 

If the merger agreement calls for the public company to pay a premium over the target company’s enterprise value, the increase in perceived value could be substantial. 

For its part, the public company’s stock will fluctuate during a merger depending on how favorably the market views it.

Reverse Merger

A reverse merger means a private company takes over a public company that is almost always smaller, often inactive, or a shell company. 

This helps them avoid the time and cost of going public through a lengthy and expensive initial public offering (IPO) process. 

The private company’s shareholders will usually receive a majority of the shares in the new entity, effectively giving them a takeover of the public company. 

This often results in the shell company's stock rising due to investors anticipating the merger. 

Following the merger, stocks may continue to rise or fall if the merger appears to be a last-ditch effort of a private company floundering for investment.

Merging companies are often similar in size and in complementary industries.  

So, it's seen as a value proposition that those two companies can combine their success in both industries and have a bigger footprint.  

However, these “horizontal mergers” often bring antitrust concerns, and the Department of Justice or the Federal Trade Commission may be involved. 

At times, another company may be formed with its stock and then own both merging companies.  

The shareholders of those companies would trade their stock for what starts as a shell company. 

In this case, the stock of each of the shareholders and the merging companies is traded for the new company, which then owns both merged companies. 

Stock Price Handling Among Shareholders

There are important legal considerations for shareholders during a company acquisition, depending upon the company's nature. 

If the company is referred to as a controlled corporation, where somewhere between 50% and 90% of the target company's ownership is controlled by either management or a small group of shareholders, it could be a management buyout.  

In that instance, a fairness determination may be required depending upon state law. This means a neutral third party will analyze or evaluate the stock's worth.

Fairness Determination

The idea of a fairness determination is to protect minority stockholders from being pushed down so the transition can proceed. The small control group determines the valuation without considering the market. 

This is based upon the concept that if there is a controlling block of shares, the majority of controlling shareholders are deemed to have a fiduciary responsibility to act in the good faith of all of the shareholders.

In this case, a fairness determination would ensure the management buyout is conducted fairly and equitably for all shareholders, not just those in control. 

Pros and Cons of Mergers

As the examples of the AT&T/Time Warner and Pfizer/Allergan mergers show, mergers can be complex and often controversial.  

While they can offer benefits, they also come with potential downsides.

Advantages for Shareholders

  • When a company is bought, its share price usually increases. An investor can sell shares on the stock exchange at any time for the current market price. 
  • The acquiring company usually offers a premium over the current stock price to entice the target company to sell.  

Once the announcement is made, traders will rush to purchase the stock at the offered price, increasing its value. 

  • If the acquiring company offers to buy the target company for the price of one share plus $10 in cash and the shares sell for $30, that equals a $40 economic value per share.  

This may cause the target company's stock to increase by that amount. In this situation, the market reaction to the acquiring company plays a role in market activity. 

  • Often, if there is even a whiff of a rumor of an impending buyout, investors begin to buy the stock before the buyout is announced, and the price of the stock increases.  

When the buyout occurs, investors reap the benefits with a cash payment.  

  • During a stock swap buyout, investors with shares may see greater corporate profits as the consolidated and target companies align.
  • When the buyout is a stock deal with no cash involved, the target company's stock tends to trade similarly to that of the acquiring company. 

Disadvantages for Shareholders

  • A disadvantage to shareholders in a company involved in a buyout is that they are no longer shareholders.  

This means if the long-term value exceeds the cash price an investor receives, they will not be able to participate or reap any rewards in the future. 

  • Investors will usually be responsible for paying income tax or capital gains tax on any cash proceeds.
  • When a stock swap buyout occurs, shares may be dispersed to the investor without interest in owning the company.
  • If the acquiring company's stock price falls, it can negatively affect the target company. If the reverse happens, and the acquiring company's stock price increases, chances are the target company's stock will also increase.
  • Dilution is another effect caused by the amount of new stock the acquiring company must issue to fund the acquisition.
  • If there is speculation of a competing offer, the price may be affected, although this is usually minor.
  • If a dividend is scheduled to be paid between the date the transaction was announced and the closing date, there can be a decrease in the stock's price.
  • The stock's price may go up or down based on rumors regarding the buyout's progress or any difficulties the deal may encounter.
  • Acquiring companies have the option to rescind their offer, shareholders may not offer support for the deal, or securities regulators may not allow the deal. 

Cash or Stock Mergers

Public companies can be acquired in cash, stock-for-stock mergers, or a combination of cash and stock.

  • Cash and Stock: With this offer, the acquiring company offers the investors in the target company cash and shares.
  • Stock-for-stock merger: Shareholders of the target company will have their shares replaced with shares of stock in the new company. The new shares will be proportionate to their existing shares. The share exchange is rarely one-for-one.

Types of buyouts might be leveraged, cash, or tender offers.  

  • Leveraged buyout: An acquiring firm can use debt to finance the target company.
  • Cash: Shares are purchased at a proposed price and are no longer in the shareholder's portfolio.
  • Tender: These offers involve an investor's proposal to buy enough outstanding shares of the target company's stock to gain a controlling interest. This is sometimes considered a hostile takeover. 

Find a Top Securities Lawyer in Your State

Stocks, mergers, buyouts, and similar transactions are complicated legal areas. A securities lawyer with expertise in corporate law and securities should be consulted to ensure the buyout is legally sound and in accordance with all applicable regulations. 

If you want to learn more about what happens to stock if a company is bought, post your legal needs on UpCounsel's marketplace to speak with a top securities lawyer in your state.  

UpCounsel accepts only the top 5% of securities lawyers on its site.  

Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience. This includes work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.