What Is an Acquisition Premium and How Does It Work?

When an acquiring company pays a price for a target company that exceeds its fair market value, this excess amount is known as an acquisition premium. It represents the value an acquirer perceives in the target beyond the sum of its assets. Understanding the premium requires knowing how it is calculated, what factors drive it, and how it is treated for accounting and tax purposes.

Calculating the Acquisition Premium

The acquisition premium is the difference between the total purchase price for a target company and its market capitalization before the acquisition is announced. The purchase price can consist of cash, the acquirer’s stock, other assets, or a combination of these. A target’s market capitalization is its number of outstanding shares multiplied by the stock price, using a price from before deal rumors could influence its value.

For example, if Target Inc. has a market capitalization of $10 billion (100 million shares at $100 per share) and Acquirer Corp. agrees to a purchase price of $12 billion, the acquisition premium is $2 billion. This premium is often expressed as a percentage. In this case, the premium would be 20%, calculated by dividing the $2 billion premium by the $10 billion market capitalization.

This percentage provides a standardized measure to compare premiums across different deals. The final amount paid can also be influenced by negotiations between the companies, the presence of other potential bidders, and overall market conditions.

Key Drivers of an Acquisition Premium

An acquiring company pays a premium for several reasons that go beyond the target’s standalone market value. The primary drivers include:

• Synergies are the anticipated benefits from combining the two companies. These can be cost synergies, such as eliminating redundant corporate functions, or revenue synergies, like cross-selling products to each other’s customer bases.
• A control premium is paid because acquiring a controlling stake gives the buyer the power to direct strategy, operations, and cash flows—a level of influence unavailable to a regular shareholder. This control has value, as the acquirer can implement changes to unlock greater performance.
• Strategic value is a factor when a target company possesses assets that are difficult or time-consuming for the acquirer to develop internally. This could include proprietary technology, valuable patents, or a well-established brand name.
• Competitive factors can drive a premium. An acquirer might pay to eliminate a rival from the marketplace to increase its market share, or it may believe the target’s assets are simply undervalued by the public market.

Accounting for the Acquisition Premium

Under U.S. Generally Accepted Accounting Principles (GAAP), an acquisition premium is not immediately expensed. It is handled through a process called Purchase Price Allocation (PPA), where the acquirer assigns the purchase price to the fair market value of the target’s identifiable assets and liabilities. This includes tangible assets like equipment and identifiable intangible assets like patents and brand names.

After this allocation, any remaining excess amount is recorded on the acquirer’s balance sheet as an intangible asset called “goodwill.” As the residual amount, goodwill captures the unidentifiable assets and strategic value that motivated the premium, such as a talented workforce, operational synergies, or a strong corporate culture.

For public companies, goodwill is not amortized, or gradually expensed over a set period. Instead, these companies must test the goodwill on their balance sheets for impairment at least once a year. If the fair value of the acquired business unit falls below its carrying value, the company must record an impairment charge, reducing both goodwill and reported earnings.

Private companies have an accounting alternative available. They can elect to amortize goodwill on a straight-line basis for a period not to exceed 10 years. If this option is chosen, impairment testing is only required if a “triggering event” suggests the asset’s value may have dropped.

Tax Implications of Goodwill

The tax treatment of goodwill differs from its accounting treatment. Under the Internal Revenue Code, the ability to deduct the cost of goodwill depends on how the acquisition is structured. Goodwill is tax-deductible in transactions structured as asset acquisitions. A stock acquisition can also result in deductible goodwill if it is legally treated as an asset acquisition for tax purposes through a specific election.

This tax-deductible goodwill is a “Section 197 intangible.” The cost of acquired goodwill must be amortized on a straight-line basis over a 15-year period, regardless of its actual useful life. This amortization provides a valuable tax shield for the acquiring company, as the annual deductions reduce its taxable income. The potential for this tax benefit can make asset sale structures more attractive to buyers.