What Is A Poison Pill Strategy?

In the world of business, takeovers happen all the time, and there are different reasons why a company would want to take control of another. The most common practice is via a merger and acquisition, in which both parties agree to the terms of the takeover. Per Investopedia, the most common reasons for taking over a company include eliminating the competition, getting more assets, diversifying, or increasing market shares, among others.

In the process of merger and acquisition, the takeover often goes smoothly. Typically, the board of directors for both companies go over the facts and come up with a new direction that will benefit both companies. Directors and some shareholders then go through a voting process. In some cases, however, a hostile takeover takes place, in which a company that wishes to acquire a business sidesteps approval from the board of directors and goes straight to key shareholders. According to The Balance, this is usually the case when the board of directors refuses to sell the business to another company. When this happens, the company can make use of the poison pill strategy to prevent a takeover from taking place, or at least delay it from happening.

When is it a hostile takeover?

In a hostile takeover, the company intending to acquire another company bypasses its leaders' consent and offers a tender offer straight to the shareholders or offers to purchase their shares at a higher price. With the acquisition of enough shares, the acquiring company can take control of a business successfully without endorsement from the board, per The Balance. Hostile takeovers can result in messy conflicts between the parties.

In early 2022, investor and business magnate Elon Musk bought $2.6 billion worth of Twitter stocks, resulting in him owning more than 9% of the company. In April, as reported by Insider, Musk contacted Twitter's chairman and offered $43 billion for the remaining shares. In a statement, he said that he wants to make social media networking service a place of free speech and to make it a much better business. In response, Twitter's board of directors unanimously agreed to a poison pill defense strategy, which made it more difficult for Musk to get a majority of shareholders to agree to the acquisition, according to PBS.

The history of the poison pill strategy

Corporate lawyer Marty Lipton was the one who invented the poison pill strategy in the early '80s. He is one of the founders of one of the world's biggest business law firms — Wachtell, Lipton, Rosen & Katz — based in New York City. According to Lipton, per The Wall Street Journal, the poison pill strategy was made to prevent hostile takeovers from happening. "We had reached a whole new plateau of hostile takeovers, and there was really very little in the way of defense to them," he said. Between the '80s and '90s, hostile takeovers in the business world were rampant.

The defense strategy is formally known as the shareholder rights plan, and it allows shareholders to purchase additional stock in the company at a discounted rate, which dilutes the holdings. This makes taking over less desirable, or drastically more costly, according to The Balance. The so-called poison pill is triggered when a company acquires or declares to acquire a certain percentage of a company's shares. The typical rate for the poison pill to be triggered is between 10% to 20% of shares acquired. The strategy got its name from the poison pills — such as cyanide pills — that spies would swallow if they were captured, thus preventing enemies from acquiring vital information, (via Investopedia).

Types of poison pill strategies

There are two types of poison pill strategies that a company can use against a hostile takeover. The first is flip-in, in which shareholders of a company are provided the opportunity to buy company shares at a lower cost. With the shares diluted, it will be more difficult for the acquiring company to increase its ownership percentage, according to The Business Professor. In this case, the acquiring company or person is prohibited from acquiring additional shares at a discounted rate.

The second type of poison pill is the flip-over option. This is utilized when a merger has already taken place and gives the shareholders the option of purchasing shares from the acquiring company at a lower rate (via Upcounsel). Shareholders also have rights that go with their shares. The poison pill strategy isn't always successful in preventing hostile takeovers from occurring, but it slows down the process and may open doors for negotiation.

Instances when the poison pill strategy was used

In 2012, streaming service giant Netflix used the poison pill defense to prevent a hostile takeover from financier Carl Icahn, who revealed that he had 9.98% control of Netflix's shares and described the company as "an example of poor corporate governance," as reported by Reuters. According to Netflix, the poison pill defense was put in place in order to protect the company and its shareholders, and it was done in the best interest of the company. In 2015, Icahn sold all his Netflix shares, per Business Insider.

In 2018, Papa John's utilized the poison pill strategy to prevent any shareholder from acquiring a controlling interest in the company. The chain's founder, John Schnatter, stepped down from his position as the CEO after reports that he used a racial slur, according to The New York Times. Schnatter owned a 30% stake in the company, making him the majority shareholder. The poison pill strategy used in this instance doubled the price of company shares for anyone who wanted to purchase shares without the approval of the board, thus preventing Schnatter from taking control of the company.

Other defense tactics to prevent hostile takeovers

Utilizing the poison pill defense has its advantages, such as preventing one shareholder from having too much control of the company and stopping a hostile takeover from occurring. However, it also has its disadvantages. The shares of the company will be diluted, and it might also discourage potential investors from placing their money into the company (via The Balance). There are other strategies as well that can be utilized aside from the poison pill defense.

One of the alternatives is the Pac-Man defense, in which the target company purchases shares from the acquiring company to stop the hostile takeover, as reported by Investopedia. Another tactic is called the crown jewel defense, which is typically used as the last plan of action. With this approach, the target company sells most of its assets, which devalues the business and makes it less desirable for the acquiring company.