What Is a Poison Pill?
"Poison pill" is a colloquial term for a defense strategy used by the directors of a public company to prevent activist investors, competitors, or other would-be acquirers from taking control of the company by buying up large amounts of its stock. Poison pills were formally called "shareholder rights plans."
Poison pills effectively block the accumulation of a company's outstanding shares. In this tactic, companies promise to distribute additional free or heavily discounted shares to all existing shareholders. The purpose of this is to dilute the shares so that outsiders can't gain control by purchasing a controlling amount of shares.
Another goal is to force the entity trying to acquire the company to negotiate with the company's board for a buyout price. Courts have upheld poison pills as a legitimate defense by corporate boards, which are not obligated to accept any offer they do not deem to be in the company's long-term interest.
- A poison pill is a defense tactic listed companies use to deter activist investors or acquirers from acquiring enough shares to take control or staging a takeover without the board's consent.
- Poison pills specify the maximum stake a shareholder may amass and dilute the holdings of all shareholders in an attempt to discourage acquirers from gaining a controlling interest.
- Because poison pills can entrench company managers and boards, companies must be able to show they are a proportional response to a credible threat.
- Investors unable to convince a company to drop its poison pill retain the option of persuading shareholders to replace the board.
Understanding Poison Pills
The poison pill frustrates "creeping acquisitions of control," in which the acquirer seeks to accumulate a controlling or dominant stake piecemeal without negotiating with the board or offering the same deal to every shareholder.
How It Works
To implement a poison pill provision, a company decides on the stake one person or entity can have. Stake, in this sense, is ownership of a company through shares. Because many shares come with ownership and voting rights, it is possible to own enough of them to purchase what's called a controlling interest.
So if an entity owns the right amount of shares, they become the stakeholder with the most stake in the company. If they have voting rights, their votes have more weight than stakeholders with fewer shares. Thus, they take over the company with the ownership and voting rights granted by owning shares.
While takeovers are still commonplace, hostile takeovers are not as common as they used to be because of tools like poison pills.
The company trying to prevent a takeover creates a provision to prevent hostile takeovers by establishing an ownership limit.
For example, a company who noticed an entity accumulating too many shares might create an ownership provision. This provision might specify that if a single entity or person acquires a company stake of 15% or more, the company will implement a share issuance. At that time, all other shareholders become eligible to acquire additional shares for a large discount or for free.
The party with the 15% stake is excluded from the stock issuance. This basically doubles the number of outstanding shares—or come close to doubling it—and cuts that party's stake in half, averting the takeover.
Poison Pill History
The poison pill tactic has been around since the 1980s, when it was devised by New York law firm Wachtell, Lipton, Rosen, and Katz amid a wave of hostile takeover and greenmail attempts by corporate raiders, since rebranded as activist investors.
Courts have ruled that poison pills are a legitimate defense against such attempts to circumvent a company board's prerogatives.
Advantages of a Poison Pill
A company's board has a fiduciary duty to protect the interests of all shareholders, while an outsider seeking control may only wish or need to satisfy a minority to gain effective control through a tender offer. A poison pill helps prevent majority control takeovers that disregard the interests of minority shareholders.
It also discourages vulture bids seeking to take advantage of a temporary decline in a share price. Market declines at the outset of the COVID-19 pandemic led hundreds of U.S. companies to adopt shareholder rights plans for that reason.
Companies with poison pill defenses have tended to garner higher takeover premiums than those without them. Industrial gasses supplier Airgas, which deployed a poison pill to resist a hostile takeover by rival Air Products and Chemicals Inc. (APD) in a landmark legal battle, sold four years later to Air Liquide for more than twice as much as Air Products offered.
Drawbacks of Poison Pills
By discouraging a motivated buyer from buying more company stock, a poison pill is likely to leave a share price lower than it would be otherwise, at least in the short run.
Poison pills can also shield underperforming board members from shareholder efforts to replace them. The good news on that score is that replacing a company 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.
Proxy advisory firms Glass Lewis and International Shareholder Services (ISS) have traditionally opposed poison pills because of their potential to entrench managers unresponsive to shareholders. As of 2022, ISS guidelines called for poison pills to have a term of no more than three years and a trigger no lower than 20% of shares outstanding. Glass Lewis generally opposes poison pills, with case-by-case exceptions for those limited in scope and motivated by a particular threat or objective.
Poison Pill Flavors: Flip-In, Flip-Over, and Dead-Hand
Most poison pills are triggered by the accumulation of a company stake above a preset threshold. These are known as flip-in shareholder rights plans, in contrast to the seldom used flip-over ones.
A flip-over poison pill is when a company allows itself to be acquired by another public company, then lets shareholders buy shares of the acquirer at a discount. You can think of this as a reverse takeover.
A dead-hand or slow-hand poison pill limits a future board's ability to remove that provision by specifying that the poison pill can only be canceled by a board majority consisting of current directors or the successors they choose. Delaware, the corporate domicile state of two-thirds of Fortune 500 companies and most recent initial public offerings, bars dead-hand poison pills, while Georgia and Pennsylvania courts have upheld them.
Poison pills often include "wolf pack" clauses applicable to the aggregate holdings of shareholders acting in concert without expressly agreeing to do so. For example, hedge fund managers commonly accumulate separate stakes of companies in pursuit of a common activist agenda without communicating the intent.
Poison Pill Examples
In early April 2022, Elon Musk threatened social media giant Twitter with a hostile takeover by disclosing he had purchased 9% of the company's shares. Twitter adopted a poison pill provision to prevent the takeover in mid-April 2022. It used 15% as its ownership threshold, which prevented anyone from taking over the company without bargaining for a fair value. By the end of April, the company agreed to a buyout by Elon Musk.
Musk purchased the company in October 2022 for $44 billion.
In July 2018, the board of restaurant chain Papa John’s (PZZA) voted to adopt a poison pill to prevent ousted founder John Schnatter from gaining control of the company. Schnatter, who owned 30% of the company’s stock, was the largest shareholder of Papa John's.
To deter a takeover attempt by Schnatter, the board adopted a poison pill expiring after a year that would permit the company to sell its stock to shareholders for half its market price if Schnatter and his affiliates increased their stake to 31%, or if anyone else amassed a 15% stake. As with all poison pills, those triggering the provision would not be allowed to buy stock on the same discounted terms, effectively diluting their stake.
When announcing the poison pill's adoption, the company stated,
"Adoption of the Rights Plan is intended to enable all Papa John’s stockholders to realize the full potential value of their investment in the company and to protect the interests of the company and its stockholders by reducing the likelihood that any person or group gains control of Papa John’s through open market accumulation or other tactics without paying an appropriate control premium."
Schnatter filed suit over some of the poison pill's provisions, settling it the following year along with other litigation against the company. He reduced his stake in Papa John's to less than 4% by 2020.
In 2012, Netflix (NFLX) announced a poison pill days after billionaire investor Carl Icahn and affiliates disclosed a stake of nearly 10%. The poison pill promised to dilute the stake of anyone acquiring more than 10% of the video streaming service provider by allowing other shareholders to purchase two shares for the price of one.
In disclosing their stake, Icahn affiliates suggested "Netflix may hold significant strategic value for a variety of significantly larger companies," adding they were "considering ways for [Netflix] to maximize shareholder value."
The Icahn funds criticized the company's adoption of a poison pill in an updated securities filing. "Any poison pill without a shareholder vote is an example of poor corporate governance, and...the pill Netflix just adopted is particularly troubling due to its remarkably low and discriminatory 10% threshold," they said.
Icahn's stake was later reduced, and eventually, it was sold for a hefty gain.
Why Are Poison Pills Used?
Poison pills prevent an activist investor or a potential acquirer from gaining control of a publicly traded company without the consent of the company's board. Deals involving the board's consent to a change of control typically provide a significant premium over the market price for all shareholders, in contrast to the share purchases in market transactions the poison pills seek to deter.
What Are the Disadvantages of Poison Pills?
Poison pills can help self-serving incumbent managers and boards frustrate shareholder efforts to oust them to improve the company's performance. As a result, corporate governance advisors recommend companies limit their scope and duration, ensure that such plans address a specific goal or threat, and have a high triggering threshold.
What's the Legal Precedent for Poison Pills?
In Delaware, where many large, listed companies are incorporated, the courts have held corporate boards have broad discretion in preventing the accumulation of controlling stakes, provided their response is proportional and based on a reasonable perception of a threat.
The Bottom Line
Poison pills are provisions companies include in their stock issuances that prevent anyone from gaining a controlling stake. They usually have share ownership thresholds set that trigger the issue of more shares to stockholders for a discount or for free.
Thus, poison pills reduce a would-be acquirer's stake in a company, forcing them to negotiate with the board for ownership rather than forcing their way in through stock ownership.