What it is:
How it works (Example):
Let's assume Company XYZ wants to acquire Company ABC. If Company ABC is worth $15 per share but Company XYZ offers $20 per share, this means Company XYZ is willing to pay a 30% acquisition premium ($20 - $15)/$15.
Although acquisition premiums can run quite high, not every company pays an acquisition premium for a target. Furthermore, not every company intentionally pays an acquisition premium.
For instance, if Company XYZ offered $20 per share when ABC was trading at $20, but then ABC shares fell to $10 per share before the acquisition was complete, Company XYZ would find itself paying a 50% premium. In most cases, however, this dramatic drop in share price would probably cause Company XYZ to withdraw its offer.
The size of the premium often depends on various factors such as competition within the industry, the presence of other bidders, and the motivations of the buyer and seller.
Why it Matters:
Most companies pay acquisition premiums for two reasons: (1) to ensure that the deal gets closed and (2) because they feel that the synergies generated by the combined entities will be greater than the total price paid for the target.
The decision of how much to pay for an acquisition target involves professional judgment beyond that which comes from evaluating spreadsheets. After all, even if paying an acquisition premium benefits the target's shareholders, paying a higher acquisition premium puts more pressure on the acquiring company to produce the results its inherited shareholders will expect.
For more information and advice on this topic, read Tips on How to Analyze an Acquisition Announcement.