Premiums and Synergy Value
A control premium is the amount a buyer pays above a target's current market value to gain control of it. A buyer is justified in paying it only when the value it expects to create, through synergies, supports the price.
Why buyers pay a control premium. A control premium is the extra amount a buyer pays over the target's unaffected share price. Control matters because the owner can set strategy, change management, redirect cash and combine operations with another business. Shareholders of the target are also being asked to give up their shares, so they expect to be paid more than the market price.
The premium is only worth paying if the buyer can create value that the target does not create on its own. Otherwise the buyer simply hands value to the seller.
How synergies are estimated. A synergy is value that exists only because the two companies are combined. Synergies usually fall into two groups:
- Cost synergies, such as removing duplicated functions or buying more efficiently at larger scale.
- Revenue synergies, such as selling the target's products through the buyer's channels.
Estimating them means identifying each source, projecting the cash flow it adds, and discounting that cash flow to a present value, using the same logic as discounted cash flow. Any one-time cost of achieving the synergy is subtracted. Revenue synergies are generally less certain than cost synergies, so estimates of them deserve more caution.
How synergy value is shared between buyer and seller. The present value of synergies is a pool of value. The premium is the part of that pool paid to the target's shareholders. The buyer keeps whatever remains.
If the premium is smaller than the synergy value, the buyer keeps some of the gain. If the premium equals it, the seller captures all the gain. If the premium is larger, the buyer pays away more than the combination creates and loses value. Each side's bargaining position affects how the pool is divided.
Testing whether a premium is supported by a synergy estimate. To test a price, compare two figures: the premium in money terms (the price minus the unaffected market value) and the stated synergy estimate in present value terms.
- Calculate the premium in money terms, not only as a percentage.
- Compare it with the synergy estimate. A premium well below the estimate leaves room for the buyer to gain.
- A premium at or above the estimate is not supported by that estimate.
- Ask how reliable the estimate is: which synergies are cost-based, which are revenue-based, and whether the cost of achieving them is included.
A premium is supported when the value the buyer expects to create covers it and still leaves the buyer a share.
