Video rental chain Hollywood Entertainment Corp. (HLYW), which may face a hostile takeover bid by industry leader Blockbuster Inc. (BBI), on Monday agreed to be bought by smaller rival Movie Gallery Inc. (MOVI) for $850 million.

The merger raises the stakes in the battle for Hollywood Entertainment's future. On Dec. 28, Blockbuster threatened to launch a hostile bid for the company if Hollywood decided to stick with a smaller previous buyout offer. A call to Blockbuster was not immediately returned.

The terms of the Movie Gallery offer call for Hollywood shareholders to receive $13.25 in cash for each of their shares, a 1.5 percent premium over Hollywood's closing price on the Nasdaq stock market on Friday. Movie Gallery would also assume $350 million of debt.

The combined company would become the No. 2 U.S. video rental chain, with about 4,500 stores in the 50 U.S. states, Canada and Mexico, and annual revenue of $2.5 billion. Blockbuster is the largest video rental chain.

Hollywood had agreed in October to be bought by Carso Holdings Corp. (search) , an affiliate of buyout firm Leonard Green & Partners LP (search) for $10.25 per share in cash.

That agreement, however, allowed Hollywood to solicit larger bids. Movie Gallery's offer is about 29 percent higher.

Blockbuster's threatened hostile bid valued Hollywood at $11.50 per share.

Movie Gallery said Joe Malugen, its chairman and chief executive, would retain those titles in the merged company. Movie Gallery would remain based in Dothan, Ala., and Hollywood in Wilsonville, Ore., with Hollywood becoming a Movie Gallery subsidiary. Blockbuster is based in Dallas.

Movie Gallery said it expects the transaction to close in the second quarter.

Merrill Lynch & Co. and Wachovia Securities Inc., and the law firms Alston & Bird LLP and Troy & Gould PC, advised Movie Gallery on the transaction, and the banks have arranged financing for it.

UBS Investment Bank and the law firm Gibson, Dunn & Crutcher LLP advised a special committee of Hollywood's board of directors, and the law firm Stoel Rives LLP advised Hollywood.