What is Control Premium?
The Control Premium (%) is the differential between the offer price per share and the acquisition target’s unaffected market share price, prior to speculative rumors of a potential M&A transaction and the official announcement.
Control Premium: Excess Purchase Price in M&A
In the context of mergers and acquisitions (M&A), the control premium is an approximation of the “excess” paid over an acquisition target’s share price by the buyer.
Control premiums are necessary for acquisitions such as leveraged buyouts (LBOs) to close, as existing shareholders require a monetary incentive to sell their shares, i.e. their ownership in the target company.
In the absence of a sufficient control premium, it is unlikely for an acquirer to successfully obtain a majority stake in the target.
Therefore, a reasonable premium is paid over the current share price in practically all acquisitions.
The control premium normally ranges from around 25% to 30%, but it can vary substantially from deal-to-deal and be as high as 50% above the target’s share price.
From the viewpoint of the pre-deal shareholders, there must be a compelling reason for them to give up their ownership — i.e. for the offer to be convincing enough, selling their shares must be profitable.
Since precedent transaction analysis (or “transaction comps”) values companies using acquisition prices for comparable companies, which factors in the control premium, the implied valuation is most often the highest relative to that derived from a discounted cash flow (DCF) or trading comps.
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Causes of Control Premium in M&A Transactions
Numerous transaction-related factors influence the size of control premiums — and the following variables listed below tend to increase the likelihood of a higher control premium.
- Revenue or Cost Synergies
- Competition Among Buyers
- Inflated Valuation Environment
- “Cheap” Financing Available
- Hostile Takeover
- Shareholders’ Reluctance to Pay
- Strategic Acquirer
The control premium can also appear higher for companies whose stock prices have been underperforming as of late.
Thus, the yearly average share price performance must also be examined to understand the details regarding the transaction, not just the trading price a few days before rumors or news articles began to circulate.
However, the transaction considerations surrounding each acquisition are unique, e.g. a certain premium could be reasonable to a buyer that anticipates realizing significant synergies, whereas the same premium can be irrational and considered to be overpaying to another buyer.
Strategic Buyers vs. Financial Buyers in M&A
The buyer profile is a notable factor that influences the size of the control premium, i.e. if the acquirer is a strategic acquirer or a financial buyer.
- Strategic Buyer: Generally, premiums are higher in deals involving a strategic acquirer (i.e. a company acquiring another company) rather than deals where the acquirer is a financial buyer (e.g. a private equity firm). The reason is strategic acquirers can usually benefit from more synergies, which directly raises the maximum amount it is willing to pay up to for the target.
- Financial Buyer: Conversely, financial buyers cannot benefit from synergies — and overpaying is a frequent mistake that results in disappointing investment returns (e.g. internal rate of return, money-on-money multiple). However, add-on acquisitions are an exception, as PE-backed portfolio companies are typically then acquiring smaller companies and can afford to pay more since synergies can be realized.
Control Premium Formula
The control premium formula consists of the two inputs.
- Offer Price Per Share: The acquirer’s offer to purchase the target on a per-share basis.
- Current “Normalized” Price Per Share: The share price of the target before news of the acquisition leaked, which causes upward or downward share price movement based on how the market perceives the deal.
The control premium equals the offer price per share divided by the current price per share, minus one.
The control premium is expressed in percentage form, so the resulting figure must be multiplied by 100.
Ensuring that the current share price is “normalized” and depicts the pre-deal market price is a crucial step — otherwise, the current share price includes the (positive or negative) impact of rumors that could have leaked to the public prior to the official announcement of the acquisition.