Poison pill defense explained: what are the pros & cons?

The short version

• A poison pill defense strategy or shareholder rights plan is used by companies to deter hostile takeovers.
• When an event is triggered, such as the hostile bidder buying a certain percentage of shares, all other current shareholders are given the chance to purchase shares at a deep discount.
• This means it will cost more for the acquiring firm to buy the company using common shares, forcing them to negotiate with the company’s board.
• While it’s an effective strategy against takeovers, it can harm shareholders as their shares are diluted and discourage other bidders from stepping forward.

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What is a poison pill defense?

A poison pill defense is a strategy employed by companies to keep hostile takeovers and acquisitions at bay. Also known as a shareholder rights plan, it’s used to make the company less desirable and to make it more expensive for the acquirer to buy shares.

There are generally two types of poison pill plans: flip-in and flip-over. They both effectively do the same thing but a flip-in is triggered by a hostile takeover while flip-over is used after a merger to discourage hostile bidders.

When a company adopts a poison pill defense, the board will specify a triggering event that gives current shareholders, and not the acquiring bidder, the right to purchase additional shares at a steep discount. This dilutes the price of the shares, ultimately increasing the bidder's costs.

It can also be used to give the company more time to evaluate its options and consider offers from other buyers. Additionally, it gives the company's board more leverage as the bidder or acquirer will often go directly to the board in an attempt to make a deal.

Poison pill defense examples

The poison pill has never been triggered by a company, although many have adopted the strategy. Some of the more recent examples of poison pill defense strategies being used include Netflix in 2012 and Papa John's in 2018.

Netflix

In 2012 American financier Carl Ichan bought a 10% stake in Netflix, hinting that the streaming service could make a good deal for a bigger tech company. He wasn’t trying to buy Netflix outright but instead, attract other buyers.

In response, Netflix adopted a poison pill defense. Under the plan, any new acquisition of 10% or more, or any merger, sale or transfer of more than 50% of assets would trigger the poison pill and allow shareholders to purchase two shares for the price of one.

Papa John’s

The board of restaurant chain Papa John’s used a poison pill in 2018 to prevent ousted founder John Schnatter from gaining control of the company by buying shares at market price. Schnatter resigned after reports that he used a racial slur during a conference call. He owned 30% of the company at the time.

The board adopted a poison pill provision known as a Limited Duration Stockholders Rights plan. It effectively doubled the share price for anyone who attempted to buy more than a certain percentage without board approval. The plan would trigger if Schnatter or his affiliates had a combined stake of 31% or purchased more than 15% of common stock.

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Why are poison pills used?

The poison pill defense is highly effective against hostile takeovers because it makes purchasing the company less attractive. Companies use this tactic to increase the cost of the acquisition and deter takeover attempts completely. It’s thought to protect minority shareholders and avoid a change in corporate leadership.

Poison pills were invented in 1982 by corporate lawyer Martin Lipton. They were used prominently in the 1980s and 1990s, especially after being upheld in a 1985 Delaware Supreme Court ruling.

Hostile bids were common during that time period, with 160 unsolicited takeover bids in 1988 alone. They became less popular in the early 200s but have risen in popularity over the last few years, with 40 companies instituting poison pill provisions between April 2019 and April 2020.

Advantages of the poison pill

The main advantage of a poison pill defense strategy is to prevent and discourage hostile takeovers. Hostile takeovers can be bad for shareholders and employees of the company. Such a move often affects morale and can lead to animosity against the acquiring firm.

It also helps prevent one shareholder from gaining too much control of the company. And it can help the company pursue better acquisitions in the future, with better value for shareholders.

While poison pills can’t completely avoid hostile takeovers, they can help slow the process down and give the board time to negotiate with the acquirer.

Disadvantages of the poison pill

Despite its effectiveness at preventing takeovers, adopting a poison pill defense can be a risky move. Here are three downsides to the strategy:

• It dilutes the shares of current shareholders
• It discourages other potential bidders from stepping forward.
• Institutional investors may also be dissuaded.

Poison pills aren’t always implemented because of shareholder interest, but rather to protect upper management at the firm. First, it takes away the potential for shareholders to be paid the premium share price that comes with takeover bids. Second, it can actually cost shareholders money, as they're forced to buy additional shares in order to maintain their percentage ownership.

It’s also possible that a poison pill defense won't work. The acquiring shareholder or company may still manage to take over the target company anyway.

Poison pill alternatives

A poison pill defense isn’t the only way that a company can prevent a hostile takeover bid. Some alternatives include:

Golden parachute: This is a contract that gives substantial benefits to top executives of a company in the event they are let go as a result of a merger or acquisition. These contracts are usually very expensive, which deters hostile takeovers. They can include stock options, severance pay, and cash bonuses.

Pac-man defense: If a target company has the resources, it can fight back by gaining financial control through various means. They may buy back some of its shares or even buy shares of the acquiring company. This can cause the hostile acquiring company to back off as they try to save their own company.

Crown jewel: In this strategy, the target company will sell off most of its assets. This makes it less attractive to the acquiring company. It can however cause long-term damage as it reduces the value of the company. It’s often a last-resort defense.

Bottom line: a poison pill defense isn’t always great for investors

While poison pill defense provisions aren’t as common as they once were, they are growing in popularity. And if Elon Musk’s bid for Twitter is any indication, these types of takeover bids can take a while to play out.

Companies like Twitter, Netflix and Papa John’s have employed poison pills to keep hostile acquisitions at bay. But that doesn’t always mean they're good for the average shareholder.

If you happen to own shares of a company with a poison pill, you’ll have to decide if you want to increase your holdings or risk having your investments diluted.