Any M&A deal involves purchase of shares of the target company by the acquiring company for a controlling stake in the firm. Before finalizing an M&A deal, the acquiring firm does an independent valuation of the prospective target to see what it is really worth. Depending on the estimated value, the acquirer adds a premium to the target so as to make the deal attractive for the target.
The premium for the target is given keeping in mind the positive synergies that the acquirer would realize upon taking over the target. It also acts like a compensation for the target company as the management is letting go of the control of their own company, which is why acquisition premium is sometimes referred to as “control premium”.
There are times when many competitive companies are evaluating a target for a possible acquisition. In such a scenario, a significant acquisition premium is given to the target so as to tackle the multiple bids that can come in.
Sun Pharma announced its decision to acquire Ranbaxy Laboratories in the year 2014. The deal was valued at $4bn. in total which translated to Rs.457 being paid by Sun Pharma for every Ranbaxy share.
The 30-day volume-weighted average share price of Ranbaxy around that time was Rs. 387. This implies an acquisition premium of around 18%.
Acquisition Premium = (457 – 387) / 387 = 18%
Sun Pharma decided to give 18% premium to Ranbaxy as it anticipated synergies of US$ 250 million from the deal, in addition to the stronger foothold that it would gain in the pharmerging markets (emerging pharma markets) post Ranbaxy’s acquisition.