Acquisition Premium (Takeover)

Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What is Acquisition Premium?

An acquisition premium is also known as the takeover premium. It is the difference in the purchase consideration, i.e., the price paid by the acquiring company to the target company’s shareholders and the target company’s pre-merged market value.

Key Takeaways

  • An acquisition premium, also known as a takeover premium, represents the difference between the purchase consideration paid by the acquiring company to the target company’s shareholders and the target company’s pre-merged market value. 
  • The takeover premium is calculated as the difference between the prices paid for the target company and the target company’s pre-merger value. Essentially, it reflects the price per share that the acquiring firm pays for the target company’s shares. 
  • The turnover premium is typically recorded as goodwill on the acquiring company’s balance sheet.

Explanation

In mergers and acquisitionsMergers And AcquisitionsMergers and acquisitions (M&A) are collaborations between two or more firms. In a merger, two or more companies functioning at the same level combine to create a new business entity. In an acquisition, a larger organization buys a smaller business entity for expansion.read more, the company acquired is called the target company, and the company that receives it is called the acquirer. TakeoverTakeoverA takeover is a transaction where the bidder company acquires the target company with or without the management's mutual agreement. Typically, a larger company expresses an interest to acquire a smaller company. Takeovers are frequent events in the current competitive business world disguised as friendly mergers.read more 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 target firm’s shares by the acquiring firm.

Takeover premium= PT – VT

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For eg:
Source: Acquisition Premium (Takeover) (wallstreetmojo.com)

Where,

  • 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 (anticipated increase in revenue, cost savings) that the acquisitions will generate. The synergies generated in M&A will be the gain of the acquirer.

The Gain of the Acquirer = Synergies Generated- 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

Where,

  • C = Cash paid to the shareholders.
  • VC*= Pre-merger value of the acquirer.

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Why does the Acquirer Pay the Extra Acquisition Premium?

Acquisition Premium Example

source – wsj.com

Acquirer pay an extra premium because of the following reasons: –

  • To minimize competition and win over the deal.
  • The synergies created will be greater than the premium paid to the target company. By synergy, we mean that the two companies, when combined, will produce greater revenue than they could do individually.

In 2016, we witnessed the world’s leading professional cloud and professional network merger. Microsoft paid $196 per LinkedIn share, a 50% acquisition premium, as they believed it would affect Microsoft’s revenue and competitive position. It was the biggest acquisition of Microsoft.

The relationship between Takeover Premium and Synergies

Higher synergies in M&A result in higher premiums. Before we go to the premium calculation, we need to understand the synergies created from the merger.

  • Cost Savings – The cost savings categories vary from company to company. The most common types include the cost of sales Cost Of SalesThe costs directly attributable to the production of the goods that are sold in the firm or organization are referred to as the cost of sales.read more, 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 make tough decisions, cost-cutting may take longer. Cost savings occur at a maximum when both companies belong to the same industry. For example, in 2005, when Procter & Gamble acquired Gillette, the management boldly decided to replace underperforming P&G workers with Gillette’s talent. It yielded good results, and P&G upper management supported this initiative.
  • Increase in Revenue– It is possible to increase revenue when combined most of the time. 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 defined Tata Sons’ growth. But on the other hand, Procter & Gamble achieved a 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 many process improvements, allowing them to increase revenue. The Disney and Pixar merger made them collaborate more easily and helped them succeed.

Takeover Premium Calculation

Method 1 – Using Share Price

One can calculate takeover premiums from share price value. For example, let us assume A Co. wants to acquire B Co. The B Co. share value is $20 per share, and A Co. offers $25 per share.

That means A Co. offers ($25- $20)/$20= 25% premium.

Method 2 – Using Enterprise Value

We can also calculate the takeover premium by estimating the company’s enterprise value Estimating the Company's Enterprise ValueThe Enterprise Value Formula is an economic measure that reflects the entire value of the organization, including secured and unsecured creditors, equity and preference shareholders, and is more commonly employed in acquiring other businesses or merging two or more businesses to achieve synergy. Enterprise value Formula = Market Capitalization + Preferred stock + Outstanding Debt + Minority Interest – Cash & Cash Equivalentsread more. The enterprise value reflects both equity and debt of the company. By taking the EV/EBITDA value EV/EBITDA ValueEV to EBITDA is the ratio between enterprise value and earnings before interest, taxes, depreciation, and amortization that helps the investor in the valuation of the company at a very subtle level by allowing the investor to compare a specific company to the peer company in the industry as a whole, or other comparative industries.read more and multiplying it by EBITDA, we can calculate the enterprise value of the firm EV Enterprise Value Of The Firm EVEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt.read more.

For example, if the enterprise value of B Co. is $12.5 million. Suppose A Co. is offering a 15% premium. Then, we get 12.5*1.15= 14.375 million. That means the premium will be $1.875 million.

Suppose the acquirer offers a higher EV/EBITDA ratio than the average EV/EBITDA multiple. Then, one can conclude that the acquirer is overpaying for the deal.

Like the Black- Scholes option pricing model, one can also use other methods for calculation. For example, 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

They found the takeover premium higher during the investor’s pessimistic market undervaluation. They found it lower during market overvaluation, a period of investor optimism. The other factors that affect acquisition premium include: –

  • The motivation of the bidders
  • The number of bidders
  • Competition in the industry
  • The type of industry

What is the Correct Price to be Paid as Acquisition Premium?

It is not easy to understand whether the acquisition premium paid overvalues or not. As in several cases, a high premium ended in better results than a lower one. But this is not always true.

Like when Quakers Oats Company acquired Snapple, it had paid $1.7 billion. However, the company did not perform well as Quaker Oats Company sold Snapple to Triarc Companies, Inc. for less than 20% of its earlier payments. Therefore, one must do proper analysis 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 records as the goodwill on the balance sheetGoodwill On The Balance SheetIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company's net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company's net identifiable assets from the total purchase price.read more. Suppose the acquirer buys it at a discount. In that case, it records as negative goodwillNegative GoodwillNegative goodwill is a negotiated purchase made by one company for acquiring the other company whose assets value more than the actual amount paid. Here, the selling company faces hardship and is ready to sell off its assets at a meager price.read more. Here, by discount, we mean less than the market price of the target company. On the other hand, if the acquirer benefits from the technology, good brand presence, and patents of the target company, then it is considered goodwill. Economic deterioration, negative cash flowsNegative Cash FlowsNegative cash flow refers to the situation when cash spending of the company is more than cash generation in a particular period under consideration. This implies that the total cash inflow from the various activities under consideration is less than the total outflow during the same period.read more, etc., account for a reduction of goodwill in a balance sheet.

Frequently Asked Questions (FAQs)

1. Where is the acquisition premium reported?

The acquisition premium, the excess amount paid for acquiring a company over its net tangible assets value, is typically reported in the financial statements as part of the goodwill. Goodwill is recorded on the balance sheet and represents the intangible value associated with the acquisition, including factors like brand reputation, customer relationships, and synergies.

2. What is the difference between acquisition premium and bond premium? 

The acquisition premium refers to the additional amount paid above the fair market value of a company’s net tangible assets in an acquisition. It represents the premium paid for acquiring intangible assets, such as brand value, customer relationships, or synergies. On the other hand, bond premium refers to the amount by which the purchase price of a bond exceeds its face value.

3. What is the market participant acquisition premium?

Market participant acquisition premium is the premium a market participant would be willing to pay to acquire a specific company or asset. It reflects the valuation and expectations of market participants based on factors such as future cash flows, growth prospects, industry trends, and strategic synergies. As a result, it helps determine the fair value of an acquisition and assess the potential return on investment.

This article is a guide to Acquisition Premium in M&A and its definition. Here, we discuss takeover premium calculation with examples and its relationship with synergies in M&A. You may also take a look at the following useful M&A articles: –

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