Acquisition Premium (Takeover)

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.

• 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.

In mergers and acquisitions, the company acquired is called the target company, and the company that receives 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 target firm’s shares by the acquiring firm.

Takeover premium= PT – VT

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.

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.

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 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.

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. 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 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.

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

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.

Turnover premium records as the goodwill on the balance sheet. Suppose the acquirer buys it at a discount. In that case, it records as negative goodwill. 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 flows, etc., account for a reduction of goodwill in a balance sheet.

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: -

• Overhead Costs Calculation
• Flip-In Poison Pill
• Friendly Takeover Example
• Crown Jewels Defense Definition