What Is a Poison Pill?

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

[Important: Poison pills are formally known as shareholder rights plans.]

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Poison Pill

How a Poison Pill Works

Poison pills mechanism is aimed at protecting the minority shareholders and to avoid the change of control or company management. Implementing a poison pill may not always indicate that the company is not willing to be acquired. It may also be effected to get a higher valuation and 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 repeal such offers for acquisition from the competitors. Without a favorable response from the target company management, the competitor desirous of 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 uses a specially designed shareholder rights plan called poison pill, which is a structural corporate development with certain conditions drafted specifically to thwart attempted takeovers.

Key Takeaways

  • A poison pill is a form of defense tactic utilized by a target company to prevent or discourage attempts of a hostile takeover by an acquirer. 
  • Such plans 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.

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. While usual investors purchase the additional shares as it provides them 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 percent of the target company’s shares. Once triggered, every shareholder (excluding the acquirer who bought 30 percent) is entitled to buy new shares at a discounted rate. The greater the number of shareholders who buy additional shares, the more diluted the acquirer’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 acquirer reduces thereby making the takeover attempt more expensive and more difficult. If a bidder is aware that such a plan could be activated, it may be inclined not to pursue a takeover. Such provisions of 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 provisions 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.

Examples of Poison Pills

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 percent 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). It granted existing investors, except for Schnatter and his holding company, a dividend distribution of one right per common share. The New York Times reports 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 announced 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, existing shareholders can purchase two shares for the price of one.

Disadvantages of Poison Pills

There are three major potential disadvantages to poison pills. The first is that stock values become diluted, so shareholders often have to purchase new shares just to keep even. The second is that institutional investors are discouraged from buying into corporations that have aggressive defenses. Lastly, 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.