Merger

A merger is when two separate companies combine to form one company. Instead of one buying the other outright and absorbing it, the two firms agree to join together, often creating a new combined entity or having one company continue under its name while the other's operations, assets, and shareholders fold into it.

Mergers happen for business reasons like combining market share, cutting costs, or entering new markets, but for a trader the important part is what happens to the stock. Shareholders of the companies involved typically end up with shares of the new combined company, cash, or some mix of both, according to an exchange ratio set out in the merger agreement. For example, holders of Company A stock might receive 0.75 shares of the new combined company for every share they held.

The nuance that trips people up is the gap between when a merger is announced and when it actually closes. A merger can be announced, agreed to by both boards, and still take months to complete while it clears shareholder votes and regulatory review. During that window the stock of the target company usually trades close to, but not exactly at, the value implied by the deal terms, with the gap reflecting the market's estimate of the risk the deal falls through. Traders who buy shares hoping to profit from that gap closing are engaging in what's called merger arbitrage.

It's also worth distinguishing a merger from an acquisition, since the two terms get used loosely. In an acquisition, one company clearly buys and absorbs another, and the acquired company's shares typically get cancelled in exchange for cash or stock. A merger implies more of a mutual combination, though in practice the legal and economic effects on shareholders can look similar.