What is Acquisition Premium?
Acquisition Premium, also known as the takeover premium, is the difference in the purchase consideration i.e. the price paid by the acquiring company to the shareholders of the target company and the target company’s pre-merged market value
In mergers and acquisitionsMergers And AcquisitionsA merger and acquisitions (M&A) agreement refers to an agreement between two existing companies to merge into a new company, or the purchase of one company by another, which is done generally to benefit from the synergy between the companies, expand research capacity, expand operations into new segments, and increase shareholder value, among other things., the company that is getting acquired is called the target company, and the company that acquires 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. 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- 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 Premium because of the following reasons –
- To minimize competitions and win over the deal.
- The synergies created will be greater than the 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 premiums. Before we go to the 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 salesCost 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., 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 some tough decisions, then cost-cutting may take longer. Cost Savings occurs at a 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 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– 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.
Takeover Premium Calculation
Method 1 – Using Share Price
Takeover premiums can be calculated from share price value. Let’s assume company A wants to acquire company B. The value of the 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% premium.
Method 2 – Using Enterprise Value
We can also calculate the takeover premium by calculating the enterprise valueCalculating The 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 Equivalents of the company. 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. and multiplying it by EBITDA, we can calculate the enterprise value of the firm EVEnterprise Value Of The Firm EVEnterprise Value is a measure of a company's total value that spans the entire market rather than just the equity value. It includes all debt and equity-based ownership claims. This value, which is calculated as the market value of debt + market value of equity - cash and cash equivalents, is particularly relevant when valuing a takeover..
For example, if the Enterprise value of company B is $12.5 million. Suppose company A is offering a 15 % premium. Then we get 12.5*1.15= 14.375 million. That means premium of (14.375 cr- 12.5 cr) = $1.875 million
Suppose 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 the 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 investor’s 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 premium ended in better results than what a lower 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 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.. If the acquirer buys it at a discount, then it is recorded 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.. 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 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., etc. account for a reduction of goodwill in a balance sheet.
This article has been a guide to Acquisition Premium in M&A and its definition. Here we discuss takeover 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 –