What is Acquisition Premium?
You’ll learn more about these benefits of acquisition premium further in this article.
Many times, when a business or an entity is looking to buy another business or corporation, they pay an acquisition premium or takeover premium to purchase it. Acquisition premium is the extra price paid by the acquirer in addition to the actual worth of the business on sale to secure the transaction. The difference between the purchase price and the fair market value is considered a goodwill asset for the buyer. At first, you might think it’s a loss to pay more than the worth of the business. However, it actually makes sense if the transaction offers certain benefits to acquirer that cannot be defined by the original value of the business. These benefits could include an upperhand over other businesses, a synergic benefit, getting market superiority, and much more.
You’ll learn more about these benefits of acquisition premium further in this article. Additionally, we will also discuss how experts carry out acquisition premium calculation and how to determine correct price for acquisition premium.
In a merger or acquisition (M&A) deal, the additional cost of purchasing the target firm is referred to as the takeover premium or acquisition premium. The business that pays to take over another is called the acquirer, while the firm that is the subject of the acquisition is called the target. Let’s dig deep to understand it better.
What is acquisition premium?
The acquisition premium is the amount paid for a firm over its estimated market worth in a merger or acquisition. That’s the price an acquiring firm pays over and above the total fair worth of the acquired company’s assets. After a merger or acquisition is finalized, the premium paid for the target is recorded as an intangible asset on the financial statements of the buyer. The term “acquisition premium” may also refer to “takeover premium”.
When a firm is bought for less than its projected worth, there is no acquisition premium. Common causes include a lack of alternative bidders and a pressing financial requirement on the part of the current shareholders. The final cost of your premium may be affected by the following variables:
- Share price changes in the targeted firm
- Industry-specific rivalry
- Contesting Offers Due to Multiple Bidders
- Motivations of the buyer and the listed business
How does acquisition premium work?
To begin the process of acquiring another business, a prospective buyer will conduct an evaluation of the target business’s true worth. Using information from its 2017 10-K filing, analysts have calculated that Macy’s market value is $11.81 billion. If more than one business is interested in purchasing the target company, the acquiring company will calculate an appealing premium to offer the target company in order to win the bidding war.
As shown above, the buyer may elect to give a 20% premium to purchase Macy’s. This means that it will offer an overall price of $14.17 billion, or $11.81 billion multiplied by 1.2. Whether this premium is approved, the acquisition premium or takeover premium will be $2.36 billion ($14.17 – $11.81), or 20% of the total purchase price.
Benefits of acquisition premium
A purchase price that exceeds the target company’s value may seem illogical at first glance. In this regard, it is important to highlight that perhaps the price at which the target firm now trades is reflective of its true market value. It’s possible, however, that the purchasing business places a higher value on the business entity than the industry does. The following are some of the benefits of acquisition premium for which an acquiring corporation could pay a takeover premium:
- Synergy – This is a common motivation where the acquirer feels that by buying a businesses can provide synergy. This happens when two businesses combine to have a greater worth than by themselves.
- Stronger market power – It’s possible that when businesses merge, there will be fewer rivals in the market. The merged firm will have more influence over commodity costs as a result. Also, a merged business may manage more areas of the supply chain, decreasing dependency on other parties.
- Growth – As a general rule, business leaders are under constant pressure to increase income. Growth may be achieved internally, but it may be more expedient to expand outside via mergers and acquisitions.
- Show the hidden value – It’s possible that the management, resources, or structure of the target firm make it unviable by itself. A buyer could restructure the target firm in the hopes of finding unrealized profit.
- Unique resources – An acquirer may engage in mergers and acquisitions (M&A) in order to expand and get access to resources that the target firm has but the acquirer does not. They may be specialized abilities or resources, such as a sophisticated R&D team, a strong sales staff, or other distinctive talents.
- Diversification – From the perspective of a business, it is possible to think of diversification as a portfolio of investments in other businesses. The company’s cash flow fluctuation may be mitigated by expanding into new markets, as a result.
- Tax considerations – In certain situations, it may be advantageous for a acquirer to purchase or combine with a target firm with high tax losses, when the acquirer may quickly cut its tax obligation.
- Management’s personal motives – There is a possibility that management will be personally driven to increase the size of their organization in order to increase their influence or their status as a result of agency difficulties.
- Cross border incentives – Consolidating or buying another company is a good way to broaden your business’s worldwide reach and tap into new consumer bases. This will become a more prevalent justification for M&A transactions as time goes on and regulations are loosened and accounting standards are standardized.
Acquisition premium calculation
The firm that is the subject of an acquisition is known as the “target company” while the “acquirer” is the business that ultimately benefits from the deal. The takeover premium or the acquisition premium is the amount by which the purchase price of the target firm exceeds its worth prior to the merger. In other words, it is the amount that the acquiring company paid for each share of the target company. We’ll see how to get acquisition premium calculation in this section.
Why does the acquirer pay an extra acquisition premium on a transaction?
The acquirer is responsible for paying a takeover premium for the following reasons:
- In order to reduce the amount of competitors and get the transaction,
- The premium paid to the target firm will be outweighed by the benefits gained from the synergies achieved. Synergy refers to the fact that the two businesses, when brought together, will be able to generate more money than each of them could on its own.
What is the right acquisition premium to pay?
The question of whether or not the takeover premium paid represents an overvalue is not simple to answer. A large premium proved to be more beneficial than a lower one in the end, as was the case in numerous other examples. However, this isn’t true all the time.
Quakers Oats Company spent $1.7 billion to purchase Snapple. Quaker Oats Company sold Snapple to Triarc Companies, Inc. for less than 20% of its previous payments, indicating the company’s poor performance. In light of this, one must do their homework before committing to a sale and not be swayed by the fact that other sellers in the market are dropping their prices.
Calculation of acquisition premium
Takeover premium is the discrepancy between how much a company was bought for and how much it was worth before the merger. The true worth of the target firm must be estimated by the purchasing company in order to determine the acquisition premium. Enterprise value or equity valuation are both viable options to calculate the true worth of the target firm.
A transaction’s acquisition premium may be estimated by dividing the difference between the amount per share spent by the purchasing company and the target company’s existing cost per share by the cost per share of the target firm at the time of the deal.
Let’s understand it better with an example.
Example of acquisition premium calculation
Say a business named PQR’s existing cost per share is $40. XYZ wants to buy PQR and is offering $50, then the acquisition premium as per the formula is (50-40) / 40 = 10/40 = 25%
Therefore, XYZ is offering to buy PQR at a takeover premium of 25%.
However, things become a little more complicated if PQR is not a publicly traded firm. The first thing XYZ has to do is determine is PQR’s enterprise value. The total worth of a company takes into account not only the stock value but also the total debt and the worth of any minority interests. With that figure in hand, XYZ may add the desired premium % to arrive at a total it is ready to pay.
Need help with applying the right acquisition premium?
Businesses that are purchased or are considering being acquired often need business valuation to determine their enterprise value. Knowing the company’s worth you’re thinking to acquire is crucial for successful negotiations, since it provides a common platform for the buyer and the seller. Need help coming to the right acquisition premium for a business that isn’t publicly traded? Eqvista can help determining its enterprise value. Contact us today and our experts can help you get started.