Poison Pill: Everything You Need to Know
A poison pill is a defense tactic companies use to deter or prevent hostile takeovers which often threaten to dilute the price of stock.13 min read
Poison Pill: What Is It?
A poison pill is a defense tactic companies use to deter or prevent hostile takeovers. These "shareholders rights plans" often threaten to dilute the price of stock enough to give the target company time to find alternative bids. It creates a cost that the purchasing company will have to pay after they've taken over. It also dilutes the value of the acquiring company's stock, to make taking over less appealing.
One company tries to wage a hostile takeover of another company by buying a large percentage of those shares. The company being taken over is called the target. The company or wealthy individual trying to take over is often called a corporate raider. The term poison pill does not refer to the target company harming their own interests. Instead, they're harming the corporate raider's interests.
Typically, corporate raiders try to increase a company's stock price when they acquire the company because they can make more money selling off parts of the company later. The poison pill brings down the value of the shares the corporate raider is trying to buy. This is how poison pill strategies help prevent hostile takeovers, though target companies have other options, too.
The term is colloquial and is a type of shareholder rights plan. It comes from spy lore, where spies would take a "poison pill" instead of giving up secrets to captors.
Versions of the poison pill include the following:
- Creating employee stock options that only vest after a company has been taken over.
- Offering stock at a huge discount.
- Taking on a large debt to make the company unappealing to acquire.
- Offering golden parachutes to executives that make replacing the executive board very expensive for the acquiring company. (A golden parachute is a huge bonus for executives who get let go in the event of a takeover.)
- Making board appointments happen over a span of time. This makes it tough for the new company when seeking board approval.
- Suicide pills, which are self-destructive acts a company might take to prevent a takeover.
Key poison pill terms are:
- Activist shareholder. An investor with a stake large enough to influence the company's management. Activist shareholders have played a role making poison pills less popular recently.
- Black knight. A company that tries a hostile takeover of another company. These are unsolicited bids on the target company.
- Chewable pill. An alternate version of the poison pill. With a chewable pill, the shareholders can ask for a vote so they can decide if a bid to acquire the company will trigger the poison pill or not. This way, companies won't automatically reject bids that might benefit shareholders.
- Proxy contest. When a black knight tries to get a group of shareholders to vote out the company's current management. The aim here is to replace those people with managers who will go for the black knight's bid.
- White knight. A company that acquires a black knight's target with a better price and more favorable terms. They "save" the target from the black knight's hostile takeover.
Why Is Poison Pill Important?
Though sometimes poison pills prevent takeovers, they often only deter acquiring companies. The costs of some of these poison pill measures are extremely high for the company to put in place. Plus, some of the measures end up harming shareholders in the long run. Shareholders are often against poison pills because the takeover might be favorable to their investments. Even if that's not the case, shareholders don't always get to vote on takeover terms.
No poison pill has ever been completely triggered, so the overall effects are still unknown. Sometimes, companies end up in an awkward position when shareholders don't want poison pills. To make investors happy, companies have to get rid of this protection.
The Poison Pill's History
The tactic began in the 1980s, thanks to Martin Lipton, a lawyer with Wachtell, Lipton, Rosen, and Katz. In 1982, T. Boone Pickens wanted to buy General American Oil. Martin Lipton told General American Oil to dilute Pickens's stock by releasing tons more stock into the market. Boards of directors have been using versions of this strategy ever since to force corporate raiders to deal with them instead of simply buying up lots of stock.
Only the board of directors can decide to use the poison pill option. They trigger when certain actions occur, like when an acquiring company tries to buy a controlling share of the corporation.
Shareholders' rights plans have four steps:
- Adoption. Invoked by the board of directors via a vote.
- Distribution. Each outstanding share of the stock gets one "right" to exercise. In order to exercise this right, the shareholder has to pay an "exercise price."
- Redemption. The "right" allows the shareholder to purchase common or preferred stock at a predetermined discount.
- Expiration. When the time limit on redeeming shareholder rights ends.
In some instances, the board offers preferred stock, which pays higher dividends. This worthless stock becomes valuable when the takeover happens. Then, the shareholders can either sell it for a good price or convert it into the corporate raider's stock.
How does the board choose the exercise price?
The board and the company's financial advisors meet to come up with a price. An exercise price is neither a way to decide the overall value of the company nor to create an acquisition price for the company.
The board and the advisors estimate the stock's long-term value during the lifetime of the shareholders' rights plan. A typical way to decide an exercise price is to multiply the stock value by three to five times, at the time the board of directors adopts the plan. Sometimes lower stock prices can cause this multiple to go up. If a company has depressed stock values or sees a high growth potential, the exercise price tends to be higher. If a company is already established, the exercise price is usually lower.
One company's exercise price has nothing to do with the exercise price another company comes up with.
Flip-in Poison Pill Option
This is the most common poison pill option. Shareholders are allowed to buy more common or preferred stock of the company facing the takeover at a discount. Shareholders have "rights" attached to the stock they already own. This allows them to pay an exercise price to use their rights. When they pay that exercise price, they're entitled to a value of common stock or participating preferred stock at market value on the transaction date. The value is some multiple of their exercise price. Usually, companies do double the exercise price. Effectively, this allows existing shareholders to get stock at a two-for-one value.
The people trying to take over the company do not get offered the shares at a discount because they do not get the option to exercise that shareholder right. The direct result is other investors in the company get a profit. It also makes it harder for the acquiring company to take over because now their shares are diluted. Taking over is more expensive after a flip-in poison pill.
Here's how it could work in the real world:
Company A wants to buy a controlling share of Company B. Company A decides to buy 25 percent of Company B's stock. But Company B has a poison pill in place that activates when someone buys 25 percent or more of their stock. This entitles the rest of Company B's shareholders, but not Company A, to buy shares of Company B at a discount.
That dilutes the stock that Company A has purchased. Their bid for Company B just became more difficult. The idea is, if Company A knows this will happen before it tries to buy so much of Company B's stock, Company A will not move forward. Company A will first seek board approval for a takeover with Company B.
Flip-Over Poison Pill Option
After the two companies merge, shareholders can buy shares from the acquiring company at a discount. Flip-overs are usually triggered after a merger, a consolidation, or the sale of a specified percentage of the company's value — typically half.
In a flip-over, shareholders also have rights attached to their shares. Every shareholder, except the acquiring company, can pay to exercise their rights, just like with a flip-in. In this case, the shareholder gets a certain value of the acquiring company's shares at market price on the transaction date. Typically it's double the exercise price, giving the same two-for-one deal in a flip-in but with the acquiring company's stock instead.
Call Plan Poison Pills
These are shareholders' rights plans that combine features of flip-in plans and flip-over plans. Call plans generally have the following features:
- Amendments. Rights plans can be changed or added to without shareholder approval. The plans just need to be redeemable and not affect the shareholders badly.
- Distribution. A right gets distributed as a dividend on one share of common stock.
- Distribution Date/Distribution of Rights. Rights get distributed on a number of days — usually 10 — after an acquiring company has bought a certain percentage of the company's common stock. Or, rights get distributed on a number of days — usually 10 — after an acquiring company has offered an exchange or a tender for a certain percentage of common stock.
- Escape Clause. The board of directors creates an escape clause for takeover instances that aren't hostile. For a small fee, the board can get the poison pill rights back from the shareholder.
- Exchange. When the board decides an exchange of a right for a share of common stock is "cashless" or a "spread."
- Exercise Price. Typically three to five times the market value of common stock at the time the call plan is adopted.
- Redemption. A very small price — between 1 cent and 5 cents — per redeemable right. This usually happens either before another company gets control or when the window period expires.
- Share Purchase Right. A right that becomes executable, allowing the stockholder to buy a portion of common stock at the right's exercise price.
- Term. How long the rights last after they've been issued. Usually, companies choose 10 years.
- Transferability. Rights are attached to common stock shares. When a distribution date happens, the rights become separate, unattached to common stock shares. These rights then trade separately, with rights certificates issued to shareholders.
- Voting. A right does not give a shareholder voting power.
Other Poison Pill Strategies
- Preferred Stock Plan. A company registers preferred stock with the SEC. It is paid as a dividend to shareholders. The preferred stock can only become common stock after a takeover has happened. Since the stock has no value until the takeover happens, it increases the value of the company's stock after a takeover. That puts unwanted merger costs on the acquiring company.
- Back-End Plan. The target company's board of directors decide on a price for cash or debt securities for shareholders. They set this up to create a selling price for the company that's above market value.
- Poison Puts. If a black knight tries to take over a target company, investors are then allowed to cash in securities — "poison puts" — before they mature. That means the black knight has to pay off these securities if they take over.
- Golden Handcuffs. To keep talented employees, companies offer deferred compensation, restricted stock, and employee stock options. These are called golden handcuffs that keep an employee with a company. Some poison pills allow employees to cash in these incentives, giving them enough wealth to leave the company after a takeover. This deprives the acquiring company of some of the target company's talent.
- Voting Plans. When an acquiring company buys lots of stock, other preferred investors get extra shareholder voting rights. This dilutes the voting power of the acquiring company.
Strengths of Poison Pills
- Poison pills are effective deterrents against hostile takeovers.
- Boards have time to find a "white knight" bidder to offer more for the company.
- Poison pills offer bargaining leverage; boards can agree not to enact poison pills if the acquiring company offers a high enough bid.
- When companies negotiate higher-cost acquisitions or mergers than a hostile takeover would provide, shareholders benefit.
- Poison pills have flexible structures, giving companies a range of options to prevent takeovers. The pill might apply to stock, bonds, CDs, notes, and options.
- Target companies can get 10 to 20 percent more from acquiring companies if they have a poison pill in place.
Weaknesses of Poison Pills
- Shareholders might benefit from a takeover when the acquiring company pays them extra for their stock.
- Companies using poison pills get a bad reputation for diluting shareholder power.
- Bad managers use poison pills to protect their positions.
- Stock values get diluted.
- Institutions who want to invest in companies don't like poison pills; institutions are often the largest investors in companies, so companies lose possible big investments.
- Sometimes shareholders will sell off their shares if a poison pill happens.
- Tesco adopted a poison pill in 2007 because Tracinda Corp and Kirk Kerkorian were trying to take over. So many shareholders reacted that stock dropped by 14 percent. By 2008, Tesco got rid of its poison pill because the shareholders were so angry.
- Fidelity Management & Research almost always votes against poison pill measures.
- Share value has gone down significantly in many instances, like with Asyst Technologies Inc. and Atmel Corp, thanks to poison pill measures.
Poison Pills Today
In 2002, according to ISS Governance Research, 60 percent of S&P 500 companies had poison pills. That number went down to 54 percent in 2004, and to 46 percent in 2005. In 2008, Thomson Financial estimated that public companies had more than 1,500 poison pill plans in place. In the next two years, 35 percent of those plans would expire. Though some companies let shareholders vote on whether to renew poison pills, most keep them without asking shareholders.
Big corporations are using poison pills less and less. These tactics had their heyday in the 1990s. Instead, more smaller companies now use poison pills. They either want to drive up the bids if someone wants to take over or want to discourage bids altogether from unwanted sources.
When the stock market fluctuates, small companies want protection against feeling undervalued. According to Blank Rome LLP's Keith Gottfried, because small companies are easier to acquire in economic hard times, they seek poison pills as protection. Companies with Net Operating Losses also use poison pills.
Overseas companies make up more than 70 percent of companies using poison pills for the first time. In the U.K., companies can't have poison pills without shareholder approval. Other European companies are still hammering out their poison pill laws. Canadian law states that shareholders can decide they want a company to make a proposal. If the shareholders vote yes, poison pills are not allowed. Canada sees a possible takeover as a decision shareholders, not directors, should make.
Chinese and Japanese companies have been hostile takeover targets, especially when compared with the U.S. In the U.S., between 2005 and 2008, 12 hostile bids that valued over $20 million occurred. The economic recession impedes hostile takeover activity.
Legal Ramifications of Poison Pill Plans
Poison pills are extremely controversial. Many legal questions have popped up since poison pills first came into being. Certain states now say poison pills are illegal, because they strip power from possible buyers.
Since the '80s, judges sometimes uphold poison pills as valid options. In 1985, one of the first poison pill cases with a favorable outcome went to the Delaware courts: Moran v. Household International, Inc. 500 A.2d 1346. The ruling concluded that poison pills are a valid defense against hostile takeovers. Conversely, Amalgamated Sugar Co. v. NL Industries, 644 F. Supp. 1229 (S.D.N.Y. 1986) ruled against poison pills.
In Bank of New York Co. v. Irving Bank Corp, 528 N.Y.S.2d 482 (N.Y. Sup. Ct. 1988), the courts ruled against what's known as a "dead hand poison pill." In dead hand poison pills, only the board members who adopted the poison pill can remove it. That would mean even if every board members was removed, they still had some control over the company.
To get rid of a poison pill, bidders go to regulators. Bidders often win these fights to have poison pills removed, because authorities side with them. Sometimes the target company can keep the poison pill if they want time to look for other bids. Right now, a company can keep a poison pill in place to prevent a hostile takeover. If they accept an offer from another bidder looking to take over the company, that offer has to be higher than the original hostile takeover attempt.
In the 80s, Revlon directors wanted to take a bid by a private equity firm. A grocery chain called Pantry Pride made higher bids, which Revlon rejected. As a result, the courts invalidated Revlon's poison pill.
Yahoo has notably had a poison pill plan in place to prevent Microsoft or another tech company from acquiring more than 15 percent of its shares.
Oracle tried to take over PeopleSoft in 2003. Their hostile takeover was valued at $5.1 billion. PeopleSoft had a poison pill they would enact if Oracle purchased 20 percent or more of PeopleSoft. Oracle ended up buying PeopleSoft for $10.3 billion after a year of negotiations when PeopleSoft voided their poison pill for the better offer.
News Corp offered shareholders the option to buy one share of stock at half price for each share they already owned. This was to fight a potential takeover.
In 2011, Airgas used a poison pill to raise the price of their own stock. This was to prevent Air Products from taking them over. Air Products took them to court for the strategy, but the courts ruled for Airgas.
Also in 2011, two companies tried to take over mining company Lundin. Lundin used a poison pill that let them offer new shares if anyone wanted to buy more than 20 percent of the company. They implemented this so they could negotiate with other companies.
Pershing Square Capital Management with Vornado Realty Trust bought 26 percent of JC Penney stock in 2010. In response, JC Penney issued a poison pill. If either of the two companies bought any more shares, JC Penney would dilute the existing shares by flooding the market.
In 2012, Carl Icahn bought 10 percent of Netflix. In retaliation, Netflix enacted a poison pill. They got rid of it in late 2013 when Icahn reduced his share to 4.5 percent.
FXCM Inc. wanted to acquire GAIN Capital Holdings Inc. in 2013. GAIN responded with a poison pill that gave one-to-one rights per share for every shareholder. Shareholders could then buy 1/100th of a share of preferred stock for each right, for just $17.
Micron Technology Inc. has a poison pill in place that activates if anyone has more than a 4.99 percent share in the company.
In 2016, Alden Global Capital LLC gained a 9.5 percent stake in Pier One Imports. Pier One's poison pill allowed shareholders to buy a fraction of a preferred share at $17.50 to dilute Alden Global Capital's stake.
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