Why Do Some Buyers Pay a Premium for a Business?

In mergers and acquisitions agreements, some buyers consider paying a premium for a business. But why? What are the benefits of this particular acquisition strategy? In fact, many …

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In mergers and acquisitions agreements, some buyers consider paying a premium for a business. But why? What are the benefits of this particular acquisition strategy? In fact, many strategic buyers will actually pay more of a price premium than financial buyers.

According to a recent report published by Pepperdine University Private Capital Markets, strategic buyers pay up to 20 percent more for middle market business acquisitions than financial buyers.

So what do we mean by “paying a premium”, and when would a buyer actually pay a premium for a business? By “premium” we mean the amount above the typical fair market value of the business that a buyer is willing to pay. Because of so-called synergies many strategic buyers can recognize an ROI that creates a more profitable enterprise between the parent and target. For example, a potential buyer might estimate the potential costs and revenue growth from combining the two companies. If the potential growth and revenue are substantial, then the buyer may consider paying a premium.

The Difference Between Vertical Integration and Horizontal Integration

When considering an acquisition strategy, many buyers will consider vertical and horizontal integration. Vertical integration is a strategy where a company expands operations into multiple steps, such as when a manufacturer owns its supplier and/ or distributor, for example. This strategy is best for companies that want to strengthen their supply chain or reduce production costs.

Horizontal integration is a strategy that involves companies acquiring a similar company in the same industry. This strategy is best for companies that want to grow by increasing its size and even diversify products and/ or services in a particular market.

Eliminate Competition

Another reason why many buyers consider paying a premium for a business is to eliminate competition. In fact, because the horizontal integration strategy involves acquiring smaller companies in a similar industry, this is one effective strategy to reduce competition.

In addition to reducing or eliminating competition, buyers may also pay a premium for a business to reduce some of their own weaknesses, such as technology, marketing, distribution, R&D and so on.

What Specifics are Buyers Looking for in a Business?

On the other hand, finding a buyer who is willing to pay a premium is based on some company specifics. For example, a buyer might consider whether or not the business generates recurring revenue. Buyers like predictability and will consider paying a premium to ensure a regular amount of income is generated each month.

Additionally, businesses with substantial market share will find a company that is considered a safer investment. Businesses with assets, such as advanced technology, legally protected intellectual property, and trade secrets will also be considered by buyers. This is because savvy buyers want to acquire a business to expand their existing assets.

For many sellers, finding a buyer who is willing to pay a premium is often the end goal. In order to attract these types of buyers, sellers should strategically build and position their businesses accordingly. This typically involves using an investment banker or M&A advisor to run a full sell-side process. Most buyers that pay a premium are looking for the potential to increase value to their shareholders. So if they believe that your business is a strategic fit, they may be more likely to pay more for the business.

Author Bio

Nate Nead is an investment banker and M&A adviser with InvestmentBank.com. He assists companies across the value chain of mergers and acquisitions, but also assists firms in raising capital for things like strategic acquisitions. His experience ranges across multiple sectors from oil & gas, software & technology, business services, consumer goods and healthcare & life sciences. He is located in Seattle, Washington.

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