There is a rich and varied academic literature on the relationship that exists between M&A and stock prices.
For decades, academics and traders alike have tried to pin down how mergers and acquisitions affect stock price over the short and long term, and whether the process adds value for those on the buying and selling side.
DealRoom help many companies organizing M&A process and below, we look at some of the main ways in which M&A transactions are said to affect stock prices.
How company stocks move during an acquisition
1. Stock price volatility
The mere mention that a company has become a target for an acquisition is usually enough to generate volatility in the stock price of both the buyer and the seller, as traders and analysts try to establish:
- what the deal means for strategy,
- how the buyer is going to pay for it,
- whether the target company is friendly or hostile to the takeover
- whether it might even trigger a bigger offer from a third party.
A good example of this can be seen in Nokia’s stock price in April 2020. When rumors abound that Nokia was the subject of acquisition interest from various parties.
This only came to light when it emerged that Nokia had hired investment bankers to ward off the interest.
The stock price, meanwhile, spiked 4% on April 17th, as opportunistic traders bought up the shares in the hope that an acquisition might come to pass.
2. Target company stock’s reaction to a bid
As a rule, acquisitions tend to drive up the value of a target company’s stock.
The rationale here is clear: buyers are invariably forced to pay a premium (i.e. a price above the current market price) to acquire the company. Thus, the listed stocks will rise in value as soon as there’s even a whisper of an impending deal.
As soon as the proposed price of the deal emerges, the stock will converge on that price as traders seek to maximize their return from the potential deal.
When IBM acquired Red Hat in 2018, it paid Red Hat’s stockholders a 63% premium on its market price on the day that the deal was announced.
A look at the stock price of Red Hat - no longer listed, as it became consolidated with IBM - shows that the stock price began a rapid ascent as soon as the acquisition was formally announced (and indeed, a little before, suggesting at least some insider trading)
3. Buying company stock’s reaction to a bid
How the stock of the buying company reacts to a bid is more nuanced than that of a selling company.
In this case, it boils down to how owners of the shares and traders on the market view the deal.
If they believe that the deal will generate value - even after the premium is taken into account - they’ll want to buy more of the stock, pushing its value up.
On the other hand, if they believe the deal will destroy value, they’ll begin offloading their stock, pushing down its value.
In either case, there’s usually an element of judgement required, and sometimes onlookers are split over whether the deal will create or destroy value for the buying firm.
When US asset management giant Charles Schwab announced that it was to acquire TD Ameritrade in November 2019, its own shares jumped nearly 8% as traders believed that the deal would add value for the former.
We can assume that part of this rationale is that it used no cash for the deal. Instead, it opted for an all-cash transaction, convincing investors in the process that the deal would be a success.
On the other hand, there’s the case of Microsoft and LinkedIn.
When Microsoft announced that it was acquiring the professional networking site for a premium of 50% over LinkedIn’s prevailing stock price, its stock price fell by 3%.
Traders and stockholders clearly felt that the company was overpaying for the stock. And with hindsight, it appears as though they may have been right in their assessment of the deal.
4. When two companies merge
The first thing to note here is that mergers in their purest sense are rare.
Most ‘mergers’ are, to a greater or lesser extent, acquisitions, where the target company has more leverage in the newly formed company than they would if it were billed as an outright acquisition.
When the new company which combines the two companies is formed, a similar logic to what happens in the case of the buying company’s stock can be seen, as the following examples illustrate.
First, if stockholders believe the merger will be a success, the market capitalization of the new company - as measured by its stock price - should be worth more than the combined value of the two companies’ stock when they were separate (the ‘1+1=3’ that all M&A practitioners desire).
A recent example of this phenomenon is provided by Spanish telecoms giant Telefónica, whose shares rose by 3% on May 3rd when its CEO announced it was exploring a merger with UK telecoms firm, Virgin. Clearly, market onlookers approved of the deal.
But if they believe that the merger won’t be a success, the stock price of the new company will be worth less than the stock of the individual entities before the transaction occurred.
A recent example of this can be seen with the proposed merger between the telemedicine companies Teladoc and Livongo - as soon as news broke of a potential $18 billion merger on May 8th, the stock of both companies plunged by double digits.
The CEOs had received a very clear message about what the market thought of the deal.
What happens to my stock after a merger and how to calculate stock price?
In the case of non-publicly traded stock, the answer to this question depends to a great extent on what was agreed to in the terms of the merger.
Recall that transactions can be paid for with cash, equity, or some combination of the two. Assuming first that the merger is agreed to, the merger will involve the creation of a new company (“NewCo”).
Now, your existing stock will be converted into the stock of the NewCo in the proportion that was agreed to in the terms of the transaction.
The reality is that even so-called “mergers of equals” aren’t exactly equal:
One of the companies in the transaction will have more revenue, higher operating margins or a better debt position (to take just three examples). That company will usually take precedence in the deal.
Let’s suppose the terms of the deal meant that NewCo was to be divided in a ratio of 55:45 between the two merging companies.
Now, 100% of your company’s stock would be diluted into 45% of NewCo’s stock (with the extra revenue from the deal compensating for the dilution).
In 1999, the US oil giants Exxon and Mobil agreed to a merger, to create what we now know as ExxonMobil (the “NewCo” in this example).
Under the terms of the deal agreed, Exxon shareholders would receive 70% of the stock of the new entity, with Mobil shareholders receiving the remainder.
The 1 billion shares in ExxonMobil were then divided in that ratio between the shareholders of each company.
The rationale for the merger was solid, but more than 20 years on, the combined firm has a share price which hovers very close to the value that it was at the time of the merger.
Should you buy stock before a merger or acquisition?
Merger arbitrage, sometimes called “merge arb,” is the process of buying stock before an expected M&A transaction - usually in the target firm - in the expectation that the value of its stock will increase when the deal is confirmed.
The rationale here is quite straightforward:
Most companies are acquired at a premium to their trading price (sometimes 30-40% higher), so any trade willing to take a punt on the deal being confirmed stands to make a profit in a relatively short period of time.
There are a couple of issues to consider when thinking about this strategy.
- First, the reality of the markets is that as soon as a deal becomes public, most of the arbitrage opportunity has already been traded out of the deal (following the principle that people don’t usually walk past ten dollar bills on the sidewalk).
- And second, if the deal falls through - as deals have a tendency of doing - you’ve bought into a stock that you took a one-way bet on, rather than holding it for any of its intrinsic value. Hence, when talking about merger arbitrage, we urge caution.
Merger arbitrage is a common strategy employed by traders. The bigger the premium offered for the target firm, the more likely arbitrageurs will have participated in trading up the stock price.
To take a recent example, pharmaceutical giant AstraZeneca acquired Alexion, a specialist in immunology, at a 45% premium to its price on the index that day.
That’s a respectable premium for anybody looking for “merge arb” but like any pharmaceutical deals, it’s likely to take a while before the deal is cleared by regulators, during which time those traders will have to wait.
What happens to stock in a reverse merger?
A reverse merger is a process through which a private company buys a public company with the intention of going public itself.
Through the transaction, it can avoid many of the legalities and expenses that come with taking a company public through an IPO.
The process is also considerably faster:
Assuming that a company can fulfill all of the criteria set out by their chosen exchange, a traditional IPO can still take as long as a year to complete. A reverse merger takes a faction of that time.
What does this all mean for your stock?
Well, it depends on which side of the transaction you hold shares. If you hold shares in the private company acquiring the public company, ceteris paribus, your shareholding in that company should remain the same after the transaction has taken place.
But if you hold stock in the public company which is the object of the acquisition, well, it works in the same way that any acquisition would: Your stock is acquired and you’ll receive whatever the buyer pays for it.
A famous example of a reverse merger (it says a lot about the success of reverse mergers that the textbook example is from so long ago) occurred in 1970 when Ted Turner, the owner of then miniscule Billboard company, acquired Rice Broadcasting.
Rice Broadcasting, based in Atlanta, was a regional broadcasting company of moderate success. What Turner wanted was its public status, providing him with much better access to credit.
This was the genesis of his Turner Broadcasting Corporation.
What happens to vested and unvested stock after a merger?
In the case of vested stock, the first point to note is that you’ve already earned the right to acquire the stock or, if you prefer, to receive a substitute cash to its value.
Legally, this has to be taken into account by the acquiring firm. And whatever they pay for the company during the merger (or acquisition) will be reflected in the price you receive.
Alternatively, instead of receiving stock in the old company, you could receive it in the newco, with the idea being the same - the stock and or cash amount must match what you’re owed.
Unvested stock is more complicated.
Given that you haven’t technically earned the stock, what happens essentially comes down to what the acquirer of your company chooses to do. Unfortunately, in most cases, your unvested stocks will simply be cancelled altogether.
The second avenue for the acquirer is to bring forward the payment to create a goodwill among the new set of employees. And the final avenue avenue is for them to make some kind of conversion between the old unvested stock and their own stock option plan.
Unfortunately, whatever they decide is up to them - you don’t get a say in the matter.
What happens to preferred stock after a merger?
Although the terms of preferred shares are specific to each company (it’s worth familiarizing yourself about what rights your preferred stock comes with before a merger arises), all preferred stock has special dividend rights.
What they don’t have is voting rights, so you won’t get a say in whether the merger goes ahead or not. However, one of two things must happen after a merger:
- either the buyer has to pay out the redemption value of the preferred stock,
- or they’ll have to continue paying its dividend.
Publicly listed stocks provide onlookers in the M&A industry with a great way of telling how the market feels about a transaction.
Although the market isn’t always right about these things, it tends to be one of the best indicators we have.
When managers of listed companies on the buy side of a transaction see that the market is selling its shares after news of an acquisition has emerged, they should be asking themselves: “Are we absolutely sure that this deal makes sense at this price?”