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What is a 'Poison Pill'

A poison pill is a tactic utilized by companies to prevent or discourage hostile takeovers. A company targeted for a takeover uses a poison pill strategy to make shares of the company's stock unfavorable to the acquiring firm.

BREAKING DOWN 'Poison Pill'

The term poison pill is the common colloquial expression referring to a specially designed shareholder rights plan.

There are two types of poison pills:

1. A “flip-in” permits shareholders, except for the acquirer, to purchase additional shares at a discount. This provides investors with instantaneous profits. Using this type of poison pill also dilutes shares held by the acquiring company, making the takeover attempt more expensive and more difficult.

2. A “flip-over” enables stockholders to purchase the acquirer’s shares after the merger at a discounted rate. For example, a shareholder may gain the right to buy the stock of its acquirer, in subsequent mergers, at a two-for-one rate.

History and Functionality of Poison Pill

In regard to mergers and acquisitions, poison pills were initially constructed 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 an option attached to existing shares. These plans, or poison pills, can only be revoked by the board. Of the two types, the flip-in variety is the most common.

A recent example of a company using a poison pill strategy is Papa John's Pizza(PZZA). Following the abrupt resignation of founder and Chairman John Schnatter in July of 2018, the company's Board of Directors adopted what it called a Limited Duration Stockholders Rights plan, granting existing investors, except for Schnatter and his holding company, a dividend distribution of one 'right', per common share. The tactic effectively makes a hostile takeover of the company unattractive as a potential acquirer would have to pay twice the value per share of the company's common stock. In the case of Papa John's, Schnatter and his affiliates own more than 30% of the company's common stock, but he was excluded from the dividend distribution, thus preventing him from trying to take over the company he founded at its market price.

Poison Pill Example

Flip-in poison pills may hold an attached option that permits shareholders to buy additional discounted shares if any one shareholder buys more than a certain percentage, or more, of the company’s shares. For example, a flip-in poison pill plan is triggered when a shareholder buys 25% of the company’s shares. When it is triggered, every shareholder, excluding the holder who purchased 25%, is entitled to buy a new issue of shares at a discounted rate. The greater the number of shareholders who buy additional shares, the more diluted the bidder’s interest becomes and the higher the cost of the bid. If a bidder is aware such a plan could be activated, it may be inclined not to pursue a takeover without board approval.

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