Control premium is an amount that a buyer is usually willing to pay over the current market price of a publicly traded company. Contrary to a widely held view, this premium is not justified by the expected synergies, such as the expected increase in cash flow resulting from cost savings and revenue enhancements achievable in the merger. Synergies are achieved whenever two companies combine their operations and therefore, should not be included in the control premium. It is accepted that synergies should be captured by the shareholders of the acquirer. The justification for the control premium lies in the expected value that the acquirer expects to achieve from obtaining control over the size and timing of the cash flows of the company as well as results from the changes in the company management that will follow the acquisition. Perhaps the target company is mismanaged and its profitability can be increased through lowering executive compensation (for example). The amount of control is the buyer's decision and is based on their belief of the value they can add to the target company.
Normally, the control premium is industry-specific and amounts to 20–50% of the market capitalization of a company calculated based on a 20-trading-day average of its stock price.
In general, the maximum value that an acquirer firm would be willing to pay should equal the sum of the target firm's intrinsic value, the value of control (or control premium), synergies that the acquiring firm can expect to achieve between the 2 firms and the opportunity cost of not acquiring the target firm (i.e. loss to the acquirer if a rival firm acquires the target firm instead).
Company XYZ has an EBITDA of $1,500,000 and is currently available for sale at an Enterprise Value(EV)/EBITDA multiple of 5x. This gives the company a valuation of $7,500,000 (=$1,500,000 * 5). A potential buyer may believe that they can improve the EBITDA to $2,000,000 by just replacing the CEO, who is currently overpaid. Thus, he could potentially value the firm at $10,000,000 since the value he expects to achieve from replacing the CEO is the extra $500,000 (=$2,000,000-$1,500,000) in EBITDA, which in turn translates to $2,500,000 (=$500,000 * 5 or =$10,000,000-$7,500,000) control premium over the initial value of the firm.
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