What it means
A bidding war needs three ingredients: a genuinely scarce asset, at least two buyers who want it, and enough information for each to know a rival is still in the race. Remove any one of them and the price usually settles quietly near the asking level.
The economics are uncomfortable for buyers. When several parties bid for something of uncertain value, the winner is by definition the one who valued it most optimistically, an effect known as the winner's curse.
Sellers and their advisers deliberately engineer these conditions. Setting a deadline for best and final offers, holding a single viewing afternoon or hinting that interest is strong are all ways of making bidders compete in real time rather than think in private.
The defence is arithmetic rather than willpower. A buyer who has calculated the maximum price that still delivers an acceptable return, and written it down before bidding opens, has something concrete to point at when the temptation arrives.
Not every escalation is irrational. If a rival owning the asset would seriously damage your business, part of what you are paying for is denial rather than the asset itself, and that value should be estimated openly instead of used as an excuse afterwards.
The consequences usually appear long after the applause has died down. In takeovers the acquiring company's share price frequently falls on the day a contested deal is won, because the market is quietly recording that the premium has been paid by one set of shareholders and received by another.
In practice
Real-world examples.
Example
Three buyers chase a two-bedroom flat listed at $420,000. The agent asks for best and final offers by Friday and the flat sells for $478,000, an escalation of $58,000 or 13.8%. The winner has to fund the extra amount from savings, because the lender's valuation only supports the original asking price.
Example
Two software groups compete for a small cybersecurity firm with $6,000,000 of recurring revenue. The opening offer of $48,000,000 rises to $71,000,000 over five weeks, taking the multiple from 8 times revenue to nearly 12 times.
Example
A hospital and a private clinic both want the same experienced radiographer. Competing counter-offers push the salary from $78,000 to $96,000 within a fortnight, and the clinic wins but has created a pay gap with its existing staff that costs a further $40,000 a year to close. The true cost of the hire is therefore closer to $136,000 than to the $96,000 on the contract.
Formula
Calculation
Maximum justifiable bid = standalone value + value of synergies
Overpayment = winning bid - maximum justifiable bid
A buyer values a target at $500,000,000 on its own numbers and believes combining the two businesses will add a further $120,000,000, so the most it can justify paying is $500,000,000 + $120,000,000 = $620,000,000. The target has 20,000,000 shares in issue, which puts the walk-away price at $620,000,000 / 20,000,000 = $31.00 per share.
Bidding opens at $28.00 and a rival pushes the price up in stages. Our buyer wins at $33.00 per share, a total of $33.00 x 20,000,000 = $660,000,000, so the overpayment is $660,000,000 - $620,000,000 = $40,000,000. That is the same as ($33.00 - $31.00) x 20,000,000, and it is value moving straight from the buyer's shareholders to the seller's.Case study
Seen in the real world.
This is an illustrative and fictional example. Penhale Foods, an invented regional grocer, wanted the freehold site occupied by Ossett Bakery, another invented business, for its eighth store, and valued the property at $3,200,000 including the cost of conversion.
A rival grocer entered the process and the two traded offers over eleven days. Penhale won at $3,950,000, which is $750,000 above its own valuation, on the argument that the rival opening there would have cost it roughly $400,000 a year in lost sales.
The finance director's review afterwards was blunt. Denying the site to a competitor was worth something real, but a $750,000 premium against $400,000 a year of protected sales only paid back if the threat was genuine and lasting, and nobody had tested that assumption before the bidding began.
Watch out
Common mistakes.
- Believing that winning the auction and winning the deal are the same thing, when the buyer who pays most is often the one who misjudged most.
- Letting the competitive process set the price ceiling instead of the buyer's own valuation work.
- Forgetting that the extra amount paid is cash today, while the benefits used to justify it are uncertain and years away.
Questions
People also ask.
Why do sellers encourage bidding wars?
Because competition transfers value from buyers to the seller, which is why deadlines, guide prices and best and final rounds are used so widely.
Is a bidding war ever rational to enter?
Yes, when the asset is genuinely scarce and you have quantified the value it creates for you, provided you stop at the number that analysis produces.
How can a buyer avoid overpaying?
Set a walk-away price in advance, require a second person to authorise any increase, and be genuinely willing to lose.
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