What Is an Acquisition Premium?
Let me explain what an acquisition premium really means. It's simply the difference between the estimated fair value of a company and the price you actually pay to acquire it in a merger or acquisition. This premium reflects the extra cost you're willing to bear when buying a target company during an M&A deal.
You should know there's no rule forcing a company to pay this premium; in some cases, you might even snag a discount depending on the circumstances.
Understanding Acquisition Premiums
In any M&A setup, the company doing the buying is the acquirer, and the one being bought is the target firm. That's straightforward.
Reasons For Paying An Acquisition Premium
Usually, you'll pay an acquisition premium to seal the deal and keep competitors at bay. You might also do it if you believe the synergies from combining operations will outweigh the total acquisition cost. The premium's size hinges on factors like industry competition, other potential bidders, and the motivations of both buyer and seller.
Keep in mind, if the target's stock price crashes, its products become outdated, or its industry faces uncertainty, you as the acquirer might pull your offer entirely.
How Does An Acquisition Premium Work?
When you're set on acquiring another firm, start by estimating its true value. Take Macy's as an example from its 2017 10-K report—its enterprise value came in at $11.81 billion. Once you've got that figure, decide how much extra you're willing to pay to make the offer appealing, especially with rivals in the mix.
In this case, if you opt for a 20% premium, your total offer would be $11.81 billion times 1.2, equaling $14.17 billion. The premium itself? That's $14.17 billion minus $11.81 billion, or $2.36 billion—20% in percentage terms.
Arriving at the Acquisition Premium
You can also calculate the premium using the target's share price. Say Macy's trades at $26 per share, and you're offering $33 per share for its outstanding shares. The premium is ($33 - $26) divided by $26, which gives you 27%.
Not every premium is intentional, though. Suppose there's no premium in the initial agreement at $26 per share, but the company's value drops to $16 before closing. Suddenly, you're paying a 62.5% premium: ($26 - $16) divided by $16.
Key Takeaways
- An acquisition premium is the difference between a company's estimated real value and the price paid in an M&A transaction.
- In financial accounting, this premium is recorded as goodwill on the balance sheet.
- You're not required to pay a premium; sometimes, you might even acquire at a discount.
Acquisition Premiums in Financial Accounting
In accounting terms, the acquisition premium is called goodwill—it's the part of the purchase price exceeding the net fair value of the assets bought and liabilities assumed. You record this goodwill as a separate item on your balance sheet.
Goodwill accounts for intangibles like the target's brand value, customer base, relations with customers and employees, and any patents or proprietary tech. If things go south—say, cash flows drop, the economy tanks, or competition heats up—goodwill can impair. That happens when the market value of those intangibles falls below what you paid, leading to a balance sheet reduction and a loss on your income statement.
On the flip side, if you buy a target for less than its fair value, you recognize negative goodwill, or badwill.
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