The Poison Pill What Is It and How Does It Work

The Poison Pill: What Is It and How Does It Work?

A poison pill is a defense strategy companies use to discourage potential buyers from making a hostile takeover bid. There are different types of poison pill strategies, like the flip over, flip in, etc. This article will discuss what a poison pill is, the different types, how it works, and also answer some of the most common questions related to it.

What is a Takeover?

A takeover is a process by which one company acquires another company. At some point, the growth rate decreases for big companies. Then they try to expand through acquisitions. Thus it has become a common trend that larger companies are taking over small companies. Other key reasons for a takeover are:

  • to increase market share,
  • to achieve economies of scale or scope,
  • to access new technology or products, and
  • to eliminate a competitor.

There are two types of takeovers: friendly and hostile.

  • In a friendly takeover, the target company agrees to be acquired.
  • In a hostile takeover, the target company does not want to be acquired and tries to resist the offer.

What Is Hostile Takeover?

A hostile takeover is when a company attempts to gain control of another company without the approval of the target company’s board of directors. This can be done by buying up a majority of the target company’s shares, making a hostile bid for the company, or launching a proxy fight to replace the target company’s board of directors with its own nominees.

Why Would Someone Make Attempt of Hostile Takeover?

There are a few reasons why someone would attempt a hostile takeover. They may believe that they can run the company better than the current management, cut costs and improve efficiency, or sell off the company’s assets for a profit. Sometimes, a hostile takeover is simply a matter of greed. The potential buyer may believe that the target company is undervalued and that they can make a quick profit by taking it over.

To know more about the hostile takeover, read this article: What is a Hostile Takeover and How Does It Work

What Is a Poison Pill?

A poison pill is a strategy companies use to make themselves less attractive to potential buyers and dissuade hostile takeover attempts. A company’s board of directors usually adopts poison pills in response to an unsolicited bid from another company.

History of Poison Pill Strategy

The poison pill strategy was first used in the early 1980s. It was popularized by Martin Lipton, a corporate lawyer who devised a strategy to help defend against hostile takeovers. Poison pills were used extensively in the 1980s and early 1990s during the wave of hostile takeover activity in the United States. It fell out of favor in the late 1990s, but they have been making a comeback in recent years.

Types of Poison Pill

There are several types of poison pills. The most common are described below.

1. Flip-Over Poison Pills

A flip-over poison pill is when a company issues new shares to existing shareholders at a discount if the company is acquired. This dilutes the potential buyer’s stake in the company and makes it less attractive to hostile bidders.

For example, let’s say that Company XYZ has 100 outstanding shares, and each share is worth $100. If an unsolicited bid is made for the company at $200 per share, the company’s total value is $20,000.

Now, let’s say that Company XYZ has a flip-over poison pill in place. Each shareholder will be issued new shares at a 50% discount if the company is acquired. So, if the company is sold for $200 per share, each shareholder will receive two new shares for every share they own.

This means that the total value of the company will be $40,000. Therefore, the hostile bidder would now need to pay $40,000 for the company instead of $20,000.

This makes the company less attractive to hostile bidders and may deter them from making an offer.

2. Redemption Poison Pills

A redemption poison pill is when a company adopts a poison pill that shareholders can redeem if the company is acquired. This type of poison pill gives shareholders the right to purchase additional shares at a discount if the company is acquired. This makes it more expensive for the potential buyer to buy the shares and discourages hostile takeover attempts.

For example, let’s say that Company XYZ has a poison pill in place that allows shareholders to purchase additional shares at a 50% discount if the company is acquired. For example, if an acquiring company wants to purchase 80% of the outstanding shares, it would need to pay $80 per share. However, with the poison pill in place, the shareholders can purchase additional shares at a 50% discount. This would make the total cost of the acquisition $120 per share. As a result, the poison pill makes it more expensive for the acquiring company to purchase the shares and discourages hostile takeover attempts.

3. Share Issuance Poison Pills

A share issuance poison pill is when a company issues new shares to anyone who purchases a certain amount of shares. This makes it more expensive for the potential buyer to accumulate a stake in the company and discourages hostile takeover attempts.

To flip the poison pill, the potential buyer would need to purchase a large enough stake in the company to give them control.

For example, let’s say ABC Inc. has a poison pill in place, and XYZ Corp wants to take them over. To do this, XYZ Corp would need to purchase a majority stake in ABC Inc. However, if the poison pill is flipped, then XYZ Corp would only be able to purchase new shares. So they would need to purchase more than 100% of a current number of shares to get more than 50% stake to take control of the company.

This type of poison pill is often used in conjunction with a flip-over provision.

Objectives of Using Poison Pill Strategy

The poison pill strategy is used for a few different reasons.

  • The most common is to make the company less attractive to potential buyers and discourage hostile takeover attempts.
  • It can also give existing shareholders more time to find a white knight.
  • It also provides more time for existing shareholders to buy more shares so that they can maintain control of the company.
  • It can help to increase the value of the company.
  • It can also help to gain bargaining power over the target company so that they can negotiate the terms of the acquisition or merger.

Pros and Cons of Poison Pill Strategy

The use of poison pills is controversial, and some investors argue that they are bad for shareholder value. However, they can be an effective way to deter hostile takeover attempts.

Arguments Supporting Poison Pill Strategy

  • Some argue that poison pills are a way for management to entrench themselves and protect their jobs.
  • It can also be used to give a company time to find a white knight, or friendly buyer, who will rescue the company from a hostile takeover.
  • It can also be used to make a hostile bidder think twice about making an offer, as they may not be able to reap the same benefits from the takeover.

Arguments Against Poison Pill Strategy

  • Others argue that poison pills are actually poison to the company. One way that it can backfire is if another bidder “flips over” the target company. In this case, it becomes poison to the original shareholders.
  • The poison pill gives the board of directors too much power to block a takeover, even if it is in the best interest of shareholders.
  • If a company’s managers are ineffective, the company can keep them in place by giving them poison pills. This will stop outside venture capitalists from coming in and cleaning the house.
  • Poison pills can also discourage takeovers, even friendly ones, which can actually be beneficial to the shareholders.
  • When a company issues new shares, the value of each individual share decreases. This is because the company is now worth more as a whole, but each share is a smaller piece of that pie. For example, if a company issues new shares so that the total number of outstanding shares doubles, the value of each share will halve.
  • Some investors don’t want to buy stock in companies with many defenses against being taken over.
  • In addition, such strategies can lead to lawsuits.

FAQs

How do poison pills protect the interest of existing shareowners?

A poison pill is a strategy used by a company to prevent a hostile takeover. It gives the existing shareholders the right to buy more shares at a discount if an outsider tries to buy a controlling stake in the company.

What is a flip-over poison pill?

A flip-over poison pill gives shareholders the right to buy shares of the company at a discount if an outsider tries to take over. This makes it more expensive for outsiders to buy enough shares to take control.

What are the differences between flip-in and flip-over poison pill strategies?

Firstly, a flip-in poison pill is only triggered if someone tries to acquire a certain percentage of the company’s shares. In contrast, a flip-over poison pill is triggered if someone tries to acquire a certain percentage of the company’s shares AND votes in favor of the takeover.
Secondly, a flip-in poison pill only affects the target company’s shareholders. In contrast, a flip-over poison pill affects both the target company’s shareholders and the acquiring company’s shareholders.

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Conclusion

A poison pill is a strategy used in business to defend against a hostile takeover. The poison pill makes it less attractive for the potential buyer by increasing the number of shares they would need to purchase or by completing the company less profitable. There are different types of poison pills, and companies should carefully consider which type is best for them before implementing one.