Deciding on a “fair” price for a takeover is hard – but ultimately a company is worth what its investors will accept. Shareholders will generally expect a hefty premium over and above the pre-bid stock price to compensate them for the hassle and loss of potential future growth. An acquirer will generally offer a 20%-plus premium over the recent share price to tempt shareholders to agree to a deal.

How does an acquirer decide on a premium? It’s not easy. A target firm’s earnings, assets, and prospects for future cash flow give you an idea of what it might be worth. And when buying a target to expand into a new business, the acquirer can figure out how much it would cost to build that business from scratch – and refuse to pay much more than that upper limit. Brand reputation plus relationships with customers and suppliers also add value.

But the thing that really drives the premium (and indeed the attractiveness of the merger in the first place) is the potential for those lovely synergies. Target shareholders need to agree they will make more by selling than from just holding onto their stock. So the acquisition needs to create additional value. But again, synergies often fail to materialize – so shareholders have to be cautious if they’re accepting stock rather than cash. Don’t get caught holding shares in an acquirer that promptly suffers, having overpaid for its target. ⛔

Who actually decides? Buyers and sellers need to agree what the target firm is worth or there’s no deal. And because that can be hard, the M&A process is riddled with advisory firms. Consultants, accountants, auditors, and bankers swoop in, offering financial analysis, due diligence, and tax advice to both buyers and sellers so that (in theory), the price is right. The only guarantee in M&A is advisors’ titanic fees, which often run to the tens of millions.

And how is the price actually paid? If the acquirer has cash reserves to dip into then it can just use these. A hard-up or miserly acquirer can turn to debt instead, taking out a big bank loan to fund the deal. But when a transaction outstrips even what the acquirer can borrow, it can pay with its own stock – though as this is usually less attractive to investors in the target company, they may well have to up the purchase price.

An acquirer can issue new shares to give to the target’s shareholders: if the acquirer’s shares are worth $100 and the target’s $50, it might offer to exchange two shares in the target for one share in the acquirer, for example. Existing shareholders in the acquirer have their stockholding diluted, now owning a smaller proportion of a much bigger pie. And this forces the target’s shareholders to take on some of the risk of the merger, with a stake in the new venture’s success. 💰

So share prices fly around like nobody’s business during M&A, but there are common trends. Next, we'll look at those – and maybe you can avoid losing out.