What is Takeover Premium in Mergers & Acquisitions?
In mergers and acquisitions, the company that is getting acquired is called the target company and the company which acquires it is called the acquirer. Takeover premium is the difference between the prices paid for the target company minus the pre-merger value of the target company. In other words, it is the price paid for each of the target firm’s shares by the acquiring firm.
Takeover premium= PT – VT
- PT = price paid for the target company
- VT = pre-merger value of the target company
The acquirer is willing to pay the acquisition premium as it expects the synergies (expected increase in revenue, cost savings) that will be generated by the acquisitions. The synergies generated in M&A will be the gain of the acquirer.
The gain of the Acquirer = Synergies generated- Takeover Premium = S- (PT- VT)
- Where S = Synergies generated by the merger.
So the post-merger value of the merged company (VC) is
VC= VC* + VT +S-C
- C = cash paid to the shareholders.
- VC*= pre-merger value of the acquirer.
Why does the Acquirer Pay the Extra Acquisition Premium?
source – wsj.com
Acquirer pay extra Acquisition Premium because of the following reasons –
- To minimize competitions and win over the deal.
- The synergies created will be greater than the acquisition premium paid for the target company. By synergy, we mean that when the two companies when combined will produce greater revenue than they could do individually.
In 2016, we witnessed the merger of the world’s leading professional cloud and the world’s leading professional network. Microsoft paid $196 per LinkedIn share, a 50% acquisition premium as they believed it would Microsoft’s revenue as well as its competitive position. It was the biggest acquisition of Microsoft.
The relationship between Takeover Premium and Synergies
Higher synergies in M&A results in higher takeover premiums. Before we go to the Takeover Premium calculation, we need to understand the synergies created from the merger.
- Cost Savings – The categories of cost savings vary from company to company. The most common categories include the cost of sales, cost of production, administrative cost, other overhead costs etc. Cost savings also depends on how much people are acceptable to change. If the senior management is not ready to take some tough decisions then cost-cutting may take longer. Cost Savings occurs in maximum when both the company belongs to the same industry. For example in 2005 when Procter & Gamble acquired Gillette, the management took a bold decision of replacing underperforming P&G workers with Gillette’s talent. It yielded good results and P&G upper management supported this initiative.
- Increase in Revenue– Most of the time, it is possible to have an increase in revenue when both of the companies are combined. But there are a lot of external factors like the reaction in a market to their merger or the competitor’s pricing (the competitors may reduce the pricing). For example, Tata Tea, a 114 $ company took a bold move by acquiring Tetley for 450 $ million which has defined the growth for Tata Sons. Procter & Gamble achieved revenue increase within one year after its merger with Gillette.
- Process Enhancement: Mergers also help in the improvement of processes. Gillette and P&G had a lot of process improvement in place which helped them achieve an increase in revenue. Disney and Pixar merger made them collaborate more easily and helped them achieve success together.
Therefore the takeover premium that will be calculated depends on the synergies that will be generated.
Takeover Premium Calculation
Method 1 – Using Share Price
Takeover premium can be calculated from share price value. Let’s assume company A wants to acquire company B. The value of Company’s B share is $20 per share and company A offers $25 per share.
This means company A is offering ($25- $20)/ $20= 25% takeover premium.
Method 2 – Using Enterprise Value
We can also calculate the takeover premium by calculating the enterprise value of the company. The enterprise value reflects both equity and debt of the company. By taking the EV/EBITDA value and multiplying it by EBITDA, we can calculate the enterprise value of the firm EV.
For example, if the Enterprise value of company B is $12.5 million. If company A is offering a 15 % takeover premium. Then we get 12.5*1.15= 14.375 million. That means acquisition premium of (14.375 cr- 12.5 cr) = $1.875 million
If the acquirer offers a higher EV/EBITDA ratio than the average EV/EBITDA multiple. It can be concluded that the acquirer is overpaying for the deal.
Other methods like Black- Scholes option pricing model can also be used for calculation. Investment banks hired by the target company will also look into the historical data of the premium paid on similar deals to provide a proper justification to the shareholder of its company.
Factors Affecting the Value of Takeover Premium
Takeover premium was found to be higher during the period of investors pessimism, market undervaluation and was found to be lower during market overvaluation, a period of investor’s optimism. The other factors that affect acquisition premium include the motivation of the bidders, number of bidders, competition in the industry and also on the type of industry.
What is the Correct Price to be Paid as Acquisition Premium?
It is difficult to understand whether the acquisition premium that is paid is overvalued or not. As in several cases, a high acquisition premium ended in better results than what a lower acquisition premium did. But this case is always not true.
Like when Quakers Oats acquired Snapple, it had paid $1.7 billion. The company did not perform well as Quaker Oats sold Snapple to Triarc Companies for less than 20% of what it had paid earlier. Therefore proper analysis should be done before going for a deal and not get instigated because the other competitors in the market are offering a greater price.
Where do we Record Turnover Premium in Books of Account for the Acquirer?
Turnover Premium is recorded as the goodwill on the balance sheet. If the acquirer buys it at a discount then it is recorded as negative goodwill. By discount, we mean less than the market price of the target company. If the acquirer benefits from the technology, good brand presence, patents of the target company then it is considered in the goodwill. Economic deterioration, negative cash flows etc. account for a reduction of goodwill in a balance sheet.
This has been a guide to Takeover Premium in Mergers and Acquisitions. Here we discuss acquisition premium calculation along with practical examples and its relationship with Synergies in M&A. You may also take a look at the following useful M&A articles –