What it means
When one company decides to buy another, the shareholders of the target will not sell at today's trading price. They want a reward for giving up control and for any future growth they are surrendering.
The buyer therefore offers a price per share above the market price, and the difference is the premium. Premiums can be large, often falling in a wide range such as 20% to 40% of the pre-deal price in typical deals, though they vary with industry and market conditions.
Hot sectors and competitive auctions push the premium up. A troubled target with few alternative buyers may attract a smaller one.
Buyers justify a premium with synergies, which are the cost savings or extra revenue that arise from combining the businesses. They may also pay a premium for strategic reasons, such as acquiring technology, customers or a market position that would take years to build alone.
The test is whether the value of those benefits exceeds the premium. The premium is not the same as goodwill, though the two are related.
The premium compares the price with the target's market value, whereas goodwill in the accounts compares the price with the fair value of the target's identifiable net assets. After a deal, a large premium can lead to a large goodwill balance that must be tested for impairment.
If the expected synergies fail to appear, the buyer has simply transferred value to the target's shareholders. Buyers sometimes overpay, so boards and investors scrutinise the premium closely.
A disciplined buyer sets a walk-away price in advance. Public takeovers add a legal dimension.
In many countries the bidder must follow disclosure and fairness rules, and the target's board has a duty to advise shareholders whether the price is adequate. Independent advisers often provide a fairness opinion to support the board's recommendation.
In practice
Real-world examples
Example 1
A large retailer bids for a smaller online competitor whose shares trade at $30. It offers $39 per share, a 30% premium. The retailer argues that shared warehouses and joint purchasing will more than justify the extra cost, and it shares its synergy estimate with its own investors.
Example 2
A pharmaceutical company acquires a biotech firm for its promising drug pipeline. It pays a 50% premium because the research is hard to replicate. The board approves it after modelling future drug sales under several scenarios.
Example 3
A private equity fund offers to buy a listed manufacturer and take it private. The offer carries a 25% premium to persuade shareholders to sell. The fund plans to recover the cost by improving operations and reducing debt.
Think of it
An acquisition premium is like paying more for a restaurant than its current value because you believe you can make it more profitable.
Formula
Calculation
Acquisition premium = Offer price per share - Pre-deal market price per share
Premium percentage = Acquisition premium / Pre-deal market price per share
A target company has 1,000,000 shares trading at $50. The buyer offers $60 per share. The premium per share is $60 - $50 = $10, so the premium percentage is $10 / $50 = 20%. The total price is $60 x 1,000,000 = $60,000,000 against a market value of $50,000,000, so the buyer is paying $10,000,000 extra.Case study
Seen in the real world
Atlas Logistics is a fictional freight company that, in this illustrative story, decided to buy a smaller rival, Fleetway, which had a market value of $80,000,000. Atlas offered $104,000,000, a premium of $24,000,000 or 30%.
Atlas's board expected annual savings of $6,000,000 from merging depots and sharing back-office teams. Over ten years, the savings were worth more than the premium, so the board agreed that the price was justified.
Two years on, only $3,000,000 of annual savings had been achieved because customers left during the integration. The board concluded that the premium had been too generous and used the lesson to set stricter integration targets for future deals. It also required a post-deal review within twelve months of every acquisition.
Watch out
Common mistakes
- Treating the premium as a cost with no benefit. Buyers pay it for synergies and control, so the question is whether those benefits are real.
- Confusing the premium with goodwill. They are calculated against different bases and appear in different places.
- Assuming a higher premium guarantees a successful deal. A big premium only raises the bar the buyer's performance must clear.
Questions
People also ask
What is a typical acquisition premium?
It varies widely, but premiums of 20% to 40% over the pre-deal share price are often seen in public company deals. Industry, competition and market conditions all affect it.
Who benefits from the premium?
Mainly the target's shareholders, who receive more than the market price. The buyer's shareholders benefit only if the deal creates more value than the premium paid.
Is the premium measured against the price before or after the announcement?
It is measured against the undisturbed price before rumours or the announcement. Using a later price would understate the premium.
Watch