Mergers and Acquisitions (M&A) can occur when companies expand and combine in order to grow or improve their business.
There are typically two parties in an M&A deal: The acquirer, or the company purchasing another company, and the target company, or the company being purchased and acquired.
Generally speaking, if both companies involved in an M&A transaction are public, the target company’s stock will no longer be traded, and shareholders will get either cash, stock, or a combination of both in the acquirer’s company.
Basics of M&A deals
Every M&A deal varies in their terms, but the two main types are all cash and all stock deals.
- In all cash deals, shareholders of the acquiree receive a set amount of cash per each share owned.
- In all stock deals, shareholders of the acquiree get their shares converted to new shares of the acquirer. A great example of this is the T-Mobile and Sprint merger in early 2020 that converted all Sprint (S) shares to shares of T-Mobile (TMUS). (You can learn more about this merger here.)
There are also other variations of M&A deals, like cash & stock deals that are a mix of both of the above, and other, more complex deals where new spin-off companies are created with their own associated shares.
About cost basis
A great example of a merger that involved a spin-off is the Raytheon (RTN) and United Technologies (UTX) merger in early 2020, which resulted in new stock for the merged company (RTX), as well as spinoff company stocks for the parts of United Technologies’ business lines that did not merge with Raytheon, like Carrier Corp (CARR) and Otis Worldwide (OTIS). (You can learn more about this merger here.)
In all M&As, your initial investment, known as the cost basis for your shares of the target company will be spread out to the new stock(s) received. In other words, your shares will convert but the value of your initial investment will stay the same, so you will not experience any additional gain or loss on the investment. It’s important to note that the average price you see on the newly converted shares may be much higher or lower than the current price of those shares on the market. This is because you are receiving these new shares at the same amount it cost you to purchase your original shares before the M&A event, not at their current stock price.
For example*, let’s say you have an initial investment of $100 in company A for 10 shares total. This is your cost basis, or the initial cost to you to own those shares.
Company A then gets acquired by company B. The terms of the deal say each share of A converts to two shares of B. Your 10 shares of A will be removed from the platform, and you will instead see 20 shares of B in your portfolio.
The initial investment of those new 20 shares of company B will still be $100, the cost basis or initial investment of your position in company A. The app will show those shares having an average price of $5, as the $100 cost basis divided by the 20 shares of B you now own is $100/20 = $5 per share.
This can get confusing if shares of company B are currently trading at $4 and you see your average price is $5. This is because you receive the shares at the same initial investment or cost basis that you originally invested in A with, and not the current price of company B stock.
Here’s another example. It’s the same as before, except this time the terms of the deal say each share of A gets $1 in cash and 2 shares of B. In this case, the cash is first taken out from your initial investment/cost basis in A (which was $100 across 10 shares). The 10 shares you own grant you $1 each a part of the deal, for a total of $10. This $10 you receive is reduced from your $100 initial investment/cost basis in A.
The remaining $90 is then spread across your new shares in Company B. Your 10 shares of A convert to 20 shares of B, and the average price per share of B becomes $90/20= $4.50.
This same principle is applied to all deals. The sum of all your new shares, or cash and shares, will equal your original initial investment or cost basis before the M&A occurred.