Discussions were continuing to finalise an all-share merger but key terms have been agreed to create one of the world's largest online betting and gaming groups with revenue of over 1.1 billion pounds, the companies said on Wednesday.
The betting sector has seen a string of deals this year as companies respond to higher tax bills in Britain and tighter regulation by looking to bulk up and better compete in an online market buoyed by the increasing use of mobiles and tablets.
"We fundamentally believe this industry is all about scale," said Betfair Chief Executive and ex-Paddy Power Chief Operating Officer Breon Corcoran, who would lead the new group.
"By putting together two distinct but phenomenally strong brands, we'll have a market leading position in the UK, Ireland, Australia and in the United States," he told Reuters.
Shares in Paddy Power and Betfair were up 18 percent and 17 percent respectively on the news.
Under the terms, Paddy Power shareholders would own 52 percent of the group with Betfair investors owning the rest. Immediately prior to completion, Paddy Power shareholders would receive a special dividend of 80 million euros ($91.9 million).
The new group would be the market leader online in the UK with a share of 16 percent, according to industry data, passing a merged Ladbrokes Coral group on 14 percent, as well as William Hill and privately owned Bet365.
Paddy Power Chairman Gary McGann would keep his role in the combined group, while its CEO Andy McCue would become COO. Betfair finance chief Alex Gersh would also stay put.
The gambling sector is seeing a wave of mergers.
Last month bookmakers Ladbrokes and Gala Coral struck an all-share deal, creating a 2.3 billion pound betting group. 888 and GVC Holdings are locked in a bidding war for online gambling firm Bwin.party Digital Entertainment.
Under the proposed merger, Corcoran said both brands will operate side by side in Europe. Paddy Power's portfolio of almost 600 betting shops, more than half of which are in Britain, will also remain part of the plans.
Betfair is an exclusively online business, best known for its technology which allows gamblers to bet against each other. Alongside its core exchange product, the firm is also targeting a larger share of the broader sports betting market.
Analysts pointed to significant scope to cut costs through the removal of duplication within the two businesses.
Davy Stockbrokers declared "the two best quality companies in the European online gaming sector are on the verge of merging".
Paddy Power is the larger of the two with a market capitalisation of 3.46 billion euros ($4 billion) at Tuesday's close, versus 2.43 billion pounds ($3.81 billion) for Betfair, which has seen its shares rise by 140 percent in a year on the back of strong revenue growth.
Both firms also gave trading updates on Wednesday.
Betfair said core earnings rose 19 percent in the three months to July 31, despite higher UK tax charges. Paddy Power said first half operating profit had grown by a third to 80 million euros against the same regulatory headwinds.