What is a poison pill?
A poison pill is a form of defense tactic used by a target company to prevent or deter attempts by a buyer to take hostile control. As the name “poison pill” suggests, this tactic is analogous to something difficult to swallow or accept. A company targeted by such a takeover uses the poison pill strategy to make its actions unfavorable to the company or to the individual buyer.
Poisoned pills considerably increase the cost of acquisitions and strongly discourage such attempts.
[Important: Poison pills are formally known as shareholder rights plans.]
How a poison pill works
The poison pill system aims to protect minority shareholders and avoid changes in control or management of the company. The use of a poison pill may not always indicate that the business is unwilling to be acquired. It can also be carried out to obtain a higher valuation and more favorable conditions for the acquisition.
With regard to mergers and acquisitions, the concept of poison pills was originally developed in the early 1980s. They were designed as a way to prevent public acquisition companies from directly negotiating a price for the sale of actions with shareholders and compel bidders to negotiate with the board of directors. Shareholder rights plans are generally issued by the board of directors in the form of a subscription warrant or an option attached to existing shares. These plans, or poisoned pills, can only be revoked by the board of directors.
Companies use all possible methods to increase their market share in the market, which includes mergers, acquisitions and strategic partnerships with other peer companies that compete in the same market. Acquiring a competitor is one such method of eliminating or reducing competition.
However, management, founders, and owners of the target business often like to retain authority over their business for emotional affinity, higher valuation, better terms, or a variety of other reasons. They may attempt to repeal these purchase offers from competitors. Without a favorable response from the management of the target company, the competitor wishing to acquire may try to take over the target company by directly addressing the shareholders of the company or fight to replace management to have the acquisition approved, which constitutes a hostile takeover.
Since shareholders – who are the actual owners of a business – can vote by majority to favor the acquisition, the management of the target company uses a specially designed shareholder rights plan called the poison pill, which is a development organizational structure with certain conditions written specifically to thwart the attempted takeover.
Key points to remember
- A poison pill is a form of defense tactic used by a target company to prevent or deter attempts by a buyer to take hostile control.
- These plans give existing shareholders the right to buy additional shares at a discount, which effectively dilutes the participation of any new hostile party.
- Poisonous pills most often come in two forms: rollover and rollover strategies.
Types of poisoned pills
There are two types of strategies for poison pills, flip-in and flip-over. Of the two types, the flip-in variety is more commonly followed.
1. Removable poison pills
A “poison pill” strategy is to allow shareholders, with the exception of the purchaser, to purchase additional shares at a discount. While regular investors buy additional shares because it gives them instant profits, the practice dilutes the value of the limited number of shares already purchased by the buying company. This purchasing right is granted to shareholders before the finalization of the takeover and is often triggered when the acquirer collects a certain threshold percentage of the shares of the target company.
Imagine that a poison pill plan is triggered when the acquirer purchases 30% of the shares of the target company. Once triggered, each shareholder (except the purchaser who bought 30%) has the right to buy new shares at a reduced rate. The more shareholders who buy additional shares, the more the interest of the purchaser is diluted and the higher the cost of the offer.
As new shares arrive on the market, the value of the shares held by the acquirer decreases, making the attempt to take control 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 provision provisions are often accessible to the public in the statutes or charter of a company and indicate their potential use as a defense against takeover bids.
2. Tipping poison pills
A “poison pill” strategy allows shareholders of the target company to buy the shares of the buying company at a greatly reduced price, if the hostile takeover attempt succeeds. For example, a target shareholder of a company may acquire the right to buy the shares of its acquirer at a rate of two to one, which dilutes the equity of the acquiring company. The purchaser can avoid pursuing these acquisitions if he perceives a dilution of the value after the acquisition.
Examples of poisoned pills
In July 2020, the board of directors of the main American catering franchise Papa John’s International Inc. (PZZA) voted to adopt the poison pill to prevent ousted founder John Schnatter from taking control of the company. Schnatter, who then owned 30% of the company’s shares, was the company’s main shareholder.
To repeal any possible takeover attempt by Schnatter, the company’s board of directors has adopted a limited-time shareholder rights plan (a provision on poison pills). It granted to existing investors, with the exception of Schnatter and its 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 its affiliates increased their cumulative ownership in the company to 31%, or if someone had to buy 15% of the common stock without the approval of the board of directors.
Since Schnatter was excluded from the distribution of dividends, the tactic effectively made a hostile takeover of the company unattractive, since the potential acquirer would have to pay twice the value per share of the company’s common shares. This prevents him from trying to take over the company he founded by buying his shares at market prices.
Another example of a poison pill defense occurred in 2020 when Netflix announced that a shareholder rights plan had been adopted by its board of directors just days after investor Carl C. Icahn acquired a 10% stake. The new plan provided that with any new acquisition of 10% or more, any Netflix merger or any sale or transfer of Netflix of more than 50% of the assets, existing shareholders can buy two shares for the price of one.
Disadvantages of poisoned pills
There are three major potential drawbacks to poisoning the pills. The first is that stock values are diluting, so shareholders often have to buy new stocks just to stay tied. The second is that institutional investors are discouraged from buying into companies with aggressive defenses. Finally, ineffective managers can stay put with poison pills; otherwise, external venture capitalists may be able to buy the business and improve its value with better personnel management.