Faced with the prospect of a hostile takeover by another company or an investor group, a corporate board might adopt a defensive strategy called a shareholder rights plan. Such plans discourage the unwelcome accumulation of company stock above a set threshold by promising to dilute an activist buyer's stake with discounted share sales to the other shareholders. The goal is to make share purchases above the limit set in the shareholder rights plan unpalatable, hence the "poison pill" nickname for the tactic.
An example of a poison pill defense occurred in 2012, when the board of Netflix, Inc. (NFLX) adopted a shareholder rights plan days after investor Carl Icahn acquired a 10% stake in the company. The poison pill stipulated that in the event of any new acquisition of 10% or more, any Netflix merger or Netflix sales or transfers of more than 50% of assets, other shareholders would be able to purchase two shares for the price of one.
Advantages of a Shareholder Rights Plan
Introduced in 1982 as hostile takeovers started shaking up corporate boardrooms, shareholder rights plans have proven effective as a delaying tactic, though they're seldom the long-term answer to activist pressure or merger interest.
A poison pill defense could help a company whose share price has suffered a short-term decline resist a vulture bid from a potential acquirer seeking to take advantage of a temporary discount. Market declines at the outset of the COVID-19 pandemic led hundreds of U.S. companies to adopt shareholder rights plans for that reason.
Disadvantages of a Shareholder Rights Plan
By discouraging a motivated buyer from buying more company stock, a shareholder rights plan is likely to leave a share price lower than it would be otherwise, at least in the short run.
Poison pills can also shield entrenched and underperforming company managers from shareholder efforts to replace them.
The good news on that score is that since shareholder rights plans are adopted by company boards, replacing a board in a proxy contest can make a poison pill go away if the new board so chooses.
Because poison pills discriminate against activist buyers and restrain trading in a company's stock, they typically require justification, and often have sunset provisions.
Shareholder rights plans cannot dilute the stakes acquired before they were adopted, so they can't reverse the accumulation of shares by activists or potential acquirers.