Control Premium

Amount paid in excess of a company's fair market value to achieve a controlling interest

What is Control Premium?

Control premium refers to an amount that a buyer is willing to pay in excess of the fair market value of shares in order to gain enough ownership interest in a publicly traded company.  A buyer that pays a control premium gains access to the firm’s cash flows, day-to-day operations, and control of the firm’s strategy. Determining how much to offer as a takeover premium is a major consideration in mergers and acquisitions.

 

Control Premium Illustration

 

Control premiums are popular during takeover bids, where large companies acquire a large number of shares in order to gain ownership control in the target. Typically, control premiums can be in the 20%-30% range of the target’s current share price, and can sometimes go up to 70%.

 

Reasons for a Control Premium

Stockholders that own a large portion of the company’s stocks can determine the direction of the company, with the minority stockholders exercising minimal influence on the company’s activities. Some of the decisions that the majority stockholders make include:

  • Select management and set their compensation
  • Register stock for a public offering
  • Liquidate, sell or merge the company
  • Buy, sell and pledge assets
  • Declare dividends
  • Make capital distributions
  • Enter and control contracts

 

When the market perceives that a public company’s profitability is not being maximized, the capital structure is not optimal, and the value of the target can be enhanced, the acquirer may be willing to pay a premium above the price currently established by the market participants. The premium paid to acquire an entity may be substantial if the target owns assets such as intellectual property or real estate that the acquirer wants to acquire.

However, if the business is on a downward trend and faces the risk of bankruptcy, a control premium would be unnecessary because the acquirer would need to invest lots of funds to turnaround the target’s business operations.

 

Amount of Control Premium

The amount of control premiums that an acquirer must pay to gain control in the target depends on whether the buyer is able to enhance the value of the company. In most cases, control premium is necessary when the target’s cash flows and profits are not being maximized. For example, if a target company is properly run, and a new ownership will not create additional value, then a control premium would be unnecessary.

The amount that a new owner would be willing to pay as control premium would depend on the incremental value that can be generated in the target company. The size of the premium is influenced by several factors, such as the potential for increasing the value of the target, competition from other buyers, as well as the views and financial needs of the current stockholders.

If the investor buys at least 51% of the target’s stocks at a control premium, they get the control to direct the business in any way they see fit. On the other hand, if the acquirer buys 35% of a business with multiple shareholders, it may not get the outright control but stands a better opportunity to command control over the other investors.

 

Example of Control Premium

Assume that ABC Company reported an EBITDA of $1,000,000 and its shares are trading at an EV/EBITDA of 5x. It will place the company’s valuation at $5,000,000 on an enterprise value basis. The potential buyer believes that ABC Company’s value can be increased to $1,500,000 by adjusting executive compensation or by removing the CEO from the company after the completion of the acquisition. It will occur when the CEO and/or the executives are paid a rate that is above the market rate.

The change will increase the company’s valuation to $7,500,000 ($1,500,000 x 5). The $2,500,000 ($7,500,000 – $5,000,000) represents the value of the control premium of the target company.

 

Takeover Premium in Financial Modeling

Below is a screenshot from CFI’s M&A Modeling Course which details how to calculate and model a takeover premium for an acquisition.

 

Control premium in M&A model

 

Justifications for a Control Premium

There are several justifications for paying a control premium for a target company:

 

Perceived synergy from the combined company

Synergy refers to the benefits derived by the working together of two or more companies for greater effect. When two companies combine to work on the same goal, they benefit from two forms of synergies, i.e. operating synergy and financial synergy. Operating synergy includes cost reductions due to the enhanced economies of scale, while financial synergy refers to the ability to generate more revenues and expand market outreach through horizontal integration.

For example, Company A is a pharmaceutical firm with strong distribution networks in North America, Canada, and Europe. Company A is willing to pay a control premium for Company B, a pharmaceutical firm with strong distribution networks in Asia and Australia. Each of the companies can use their counterpart’s distribution networks to increase their product distribution and benefit from operating and financial synergies.

 

Undervalued by the market

An acquirer may pay a higher control premium if it perceives the target company to be undervalued. In such scenarios, the company may be acquired if the undervaluation by the market is greater than the uplift that is applied when a bid is made. If the acquirer possesses enough data to support the valuation, it can pay a premium price as long as the cost of acquisition does not exceed the valuation.

Potential buyers should develop a concrete plan to ensure that the potential synergies and benefits of implementing the acquisition can be converted into the actual value. Most acquirers implement such acquisition strategies within a short duration to avoid waking up the market, which may bring unnecessary competition.

 

Poor management

An acquirer may consider paying a control premium if they perceive that replacing the management of the company can increase the value of the company. The acquirer may have a low perception of the management and by acquiring the company at a premium, it may enjoy various benefits by instituting better direction and control mechanisms in the target. If the management team’s performance is above average and their remuneration is above the prevailing market rate, the acquirer may consider replacing them with other executives of equal ability but at reduced costs.

 

Related Readings

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

M&A Modeling Course

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