The amount of monetary difference between the estimated amount and the actual amount for acquiring a company.
How Acquisition Premium Works
Acquisition premiums represent the cost increase during acquisition and merging. Paying a premium when one company wants to acquire another is not a requirement. The company buying the other company might, in some circumstances, get a discount during the transaction. The acquirer is the company that pays to buy another company during the merging and acquisition scenario.
The target firm, on the other hand, is the acquired company. There are several reasons why the acquiring company might pay an acquisition premium. These reasons include averting competition and closing deals. The acquirer may also use it when the acquirer believes that the target company's acquisition cost is less than the created synergy.
Some factors affect the premium size, including bidders' presence, seller and buyer motivation, and industry competition. When a company decides to acquire another company or firm, its first step is to estimate the target company value. After estimating the price, the company decides how much more money they are willing to spend on the acquisition. The need for acquisition premium is to create an attractive deal, mainly when other companies are willing to acquire the same firm.
Real-World Example of Acquisition Premium
For instance, a company by the name Gimic wants to acquire another company by the name Cjinc. Each share of Cjinc is worth $15. However, Gimic offers the target company a price of $20 per share. According to the formulas of calculating the acquisition premium (acquisition premium = (target company offer – actual worth of the target company) / (actual worth of the target company)), the acquisition premium will be 30%.
Acquisition premiums can be pretty high; however, not all target companies are paid the acquisition cost. Besides, every company has to pay the acquisition premium.
For example, if Gimic were willing to offer Cjinc a similar price of shares like theirs, which is $20 before the acquisition process happens, Cjinc's shares would fall to $10 per share. Gimic company will end up paying a premium of 50% to Cjinc. However, this is rare, as most companies withdraw their offer whenever this event occurs.
Significance of Acquisition Premium
When it comes to financial accounting, we refer to the acquisition premium as goodwill. When it comes to recording the transaction on the balance sheet, the acquiring company creates a separate account. In intangible assets like good customer relations, solid customer base, proprietary or patent technology, the goodwill factors. Many factors can impair goodwill, like an environment that is quite competitive, economic depression, and cash flows decline.
Whenever the target company's intangible assets fall below the acquisition cost, there is an impairment of goodwill. On the balance sheet, the impairment will decrease, and on the income statement, it will exhibit a loss. There is also negative goodwill which is when an acquirer buys a target firm at a discount that is less than the fair value.