What is Poison Pill?

A poison pill is a type of defense tactic utilized by a target company to prevent, or discourage, attempts of a hostile takeover by an acquirer.


Poison pills are formally known as shareholder rights plans

Key Takeaways

  • A poison pill is a type of defense tactic utilized by a target company to prevent, or discourage, attempts of a hostile takeover by an acquirer.
  • Poison pills allow existing shareholders the right to purchase additional shares at a discount, effectively diluting the ownership interest of any new, hostile party. 
  • Poison pills most often come in two forms: the flip-in and flip-over strategies.

Poison Pill

Understanding Poison Pill

As the name "poison pill" indicates, this tactic is analogous to something that is difficult to swallow or accept. A company targeted for such a takeover uses the poison pill strategy to make its shares unfavorable to the acquiring firm or individual. Poison pills significantly raise the cost of acquisitions and create big disincentives to deter such attempts completely.

A poison pills mechanism is aimed at protecting the minority shareholders and to avoid the change of control of company management. Implementing a poison pill may not always indicate that the company is not willing to be acquired. At times, it may be enacted to get a higher valuation or more favorable terms for the acquisition.

With regard to mergers and acquisitions, the concept of poison pills was initially drafted in the early 1980s. They were devised as a way to stop bidding takeover companies from directly negotiating a price for the sale of shares with shareholders and instead force bidders to negotiate with the board of directors. Shareholder rights plans are typically issued by the board of directors in the form of a warrant or as an option attached to existing shares. These plans, or poison pills, can only be revoked by the board.

Companies utilize all possible methods to increase their business share in the marketplace, which include mergers, acquisitions, and strategic partnerships with other peer companies who compete in the same market. Acquiring a competitor is one such method to eliminate or reduce competition.

However, the management, founders, and owners of the target company often like to retain their authority over their business for emotional affinity, higher valuation, better terms, or various other reasons. They may attempt to repel such offers of an acquisition from competitors. Without a favorable response from the target company's management, the competitor interested in an acquisition may attempt to take over the target company by going directly to the company's shareholders or fight to replace management to get the acquisition approved, which constitutes a hostile takeover.

Since shareholders—who are the actual owners of a company—can vote by majority to favor the acquisition, the target company management deploys a poison pill, which usually is a specially designed shareholder rights plan with certain conditions drafted specifically to thwart attempted takeovers.

Types of Poison Pills

There are two types of poison pill strategies, flip-in and flip-over. Of the two types, the flip-in variety is more commonly followed.

  1. Flip-In Poison Pills - A "flip-in poison pill" strategy involves allowing the shareholders, except for the acquirer, to purchase additional shares at a discount. Though purchasing additional shares provides shareholders with instantaneous profits, the practice dilutes the value of the limited number of shares already purchased by the acquiring company. This right to purchase is given to the shareholders before the takeover is finalized and is often triggered when the acquirer amasses a certain threshold percentage of shares of the target company. Let's say a flip-in poison pill plan is triggered when the acquirer purchases 30% of the target company’s shares. Once triggered, every shareholder (excluding the acquirer who bought 30%) is entitled to buy new shares at a discounted rate. The greater the number of shareholders who buy additional shares, the more diluted the acquiring company's interest becomes and the higher the cost of the bid. As new shares make way to the market, the value of shares held by the acquirer reduces, thereby making the takeover attempt more expensive and more difficult. If a bidder is aware that such a plan could be activated, they may be inclined not to pursue a takeover. Such provisions of a flip-in are often publicly available in a company's bylaws, or charter, and indicate their potential use as a takeover defense. 
  2. Flip-Over Poison Pills - A "flip-over poison pill" strategy allows for stockholders of the target company to purchase the shares of the acquiring company at a deeply discounted price if the hostile takeover attempt is successful. For example, a target company shareholder may gain the right to buy the stock of its acquirer at a two-for-one rate thereby diluting the equity in the acquiring company. The acquirer may avoid going ahead with such acquisitions if it perceives a dilution of value post-acquisition.

Poison Pill Examples

In July 2018, leading American restaurant franchise Papa John’s International Inc.’s (PZZA) board voted to adopt the poison pill to prevent ousted founder John Schnatter from gaining control of the company. Schnatter, who then owned 30% of the company’s stock, was the largest shareholder of the company.

To repeal any possible takeover attempts by Schnatter, the company's board of directors adopted a Limited Duration Stockholders Rights plan (a poison pill provision). Dubbed the "wolf-pack provision", It essentially doubled the share price for anyone who attempts to amass more than a certain percentage of the company’s shares without board approval. The New York Times reported that the plan would take effect if Schnatter and his affiliates raised their combined stake in the company to 31%, or if anyone were to buy 15% of the common stock without the board’s approval.

Since Schnatter was excluded from the dividend distribution, the tactic effectively made a hostile takeover of the company unattractive as the potential acquirer would have to pay twice the value per share of the company's common stock. It prevented him from trying to take over the company he founded by buying its shares at market price.

Another example of a poison pill defense occurred in 2012 when Netflix (NFLX) announced that a shareholder rights plan had been adopted by its board just days after investor Carl C. Icahn acquired a 10% stake. The new plan stipulated that with any new acquisition of 10% or more, any Netflix merger or Netflix sales or transfers of more than 50% of assets, allows for existing shareholders to purchase two shares for the price of one.

Disadvantages of Poison Pills

There are three major potential disadvantages to poison pills.

  1. Stock values become diluted, so shareholders often have to purchase new shares just to keep even.
  2. Institutional investors are discouraged from buying into corporations that have aggressive defenses.
  3. Ineffective managers can stay in place through poison pills; otherwise, outside venture capitalists might be able to buy the firm and improve its value with better managing staff.