Companies will go to great lengths to maintain control of their firms and will discourage a hostile takeover at any cost. One effective strategy that companies employ is called the poison pill. This tactic involves diluting a takeover company’s ownership interest in the company they wish to acquire and making it prohibitively more expensive for them to continue to purchase shares.
Poison pills have been a popular, yet controversial move and their legality has even come into question. Their use can be beneficial or detrimental to shareholders depending on the situation. Sill, a poison pill almost always acts as a strong deterrent to anyone interested in a hostile takeover bid.
How Does the Poison Pill Work?
Essentially, poison pills are used to dilute the acquiring company’s ownership. This is conducted by issuing stocks, warrants, or options to existing shareholders that become exercisable once the takeover company acquires a fixed percentage of the target company’s stock (often at a significant discount to the current price). Poison pills are usually triggered when one investor obtains an ownership interest of 20%.
While there are a variety of ways poison pills may be constructed, one common way is to make long-term director options immediately exercisable, thereby diluting the potential suitor’s ownership and maintaining the existing board’s voting power. Alternatively, current shareholders may be given the right to purchase additional shares at a deep discount, making it much more expensive for the target company to get acquired.
Poison pills may be used in different scenarios. For example, management may want to deter a hostile takeover in order to preserve their jobs. Or, sometimes, a company doesn’t mind being bought out, but is not interested in the specific company attempting to do so. In the latter case, using a poison pill can buy a company time in which to seek a more favorable company to buy them out instead.
Advantages of Poison Pill Strategies
The use of poison pills can be advantageous for both shareholders and management.
- Extremely effective. Historically, poison pills have a high rate of success. They are actually one of the most useful tactics for fighting a takeover. This can be a good thing for investors, especially if they are concerned that a takeover will not be beneficial to the organization.
- Informal structure. The poison pill is a flexible system that can be tailored to a company’s needs. They can structure which assets the pricing terms apply to, such as convertible bonds, notes, stocks, options, bonds, and CDs.
- Protects against unscrupulous buyers. Every company that initiates a hostile takeover does so for their own benefit. They may intend to dismantle their target and sell it piece by piece, or they may lack the industrial insight and experience to run the company effectively. As a result, the target company may create a poison pill to protect themselves from a buyer that would ultimately hurt management and existing shareholders.
- Gives management time to seek other offers. Rather than prevent a takeover, poison pills can provide management the opportunity to find a better offer or create a bidding war.
- Obtain higher premiums. Studies suggest that firms with poison pills receive a 10% to 20% higher premium from acquiring firms over companies that do not have a poison pill in place.
Disadvantages of the Poison Pill
Although poison pills provide a number of benefits to corporations and investors, they can also be risky. The practice of using poison pills to fight takeover attempts has come under scrutiny both by critics and the courts in recent years for some of the following reasons:
- Dilutes the value of stock. When companies issue a number of new shares at a discount, they are saturating the supply of stock. This ends up reducing the value of existing shares and investors are forced to purchase new shares in order to maintain their prior ownership percentage.
- Investors forgo profit from a takeover. During a takeover, investors are often paid a premium for their stock. Therefore, the use of a poison pill may deprive investors of potentially hefty profits. Unfortunately, investors who would prefer that the takeover go through successfully don’t have much power to fight a poison pill.
- Poison pills tend to protect poor managers. Companies that are the targets of takeovers are often subject to poor performance. The acquirer typically realizes that the target company has major room for improvement if managed properly. As a result, poison pills are instituted by management to protect their own jobs and, ultimately, deprive investors of a better management team.
- Discourages institutional investors. Institutional investors have been increasingly apprehensive about poison pills since they can make it easy for management to make selfish decisions at the expense of shareholders. For example, a CEO who makes $10 million per year will have a huge incentive to turn down any takeover offer in order to preserve his or her job. Since takeover premiums sometimes offer the highest return for shareholders, they can lead to decreased institutional interest in the company, which can in turn hurt stock prices since institutions are the largest buyers. Ultimately, institutions are less likely to invest in a company that purposely looks to scare off potential suitors.
Examples of Poison Pills
There are a number of companies that have used poison pills to dissuade takeover attempts. Some of the more famous examples include:
- News Corp. News Corp used a poison pill to fight against a possible takeover. They gave investors the right to purchase one share of stock at a 50% discount for every share they owned.
- Airgas. Air Products threatened to buy out Airgas in the beginning of 2011. Airgas was opposed to a takeover and used a poison pill strategy to place the stock price higher than Air Products would want to pay. Air Products tried taking them to court to nullify the poison pill, but they were unsuccessful.
- Lundin. Lundin, a copper and zinc mining company, rejected two takeovers in March 2011 and used a poison pill to thwart one of them. They put together a poison pill clause allowing them to issue new shares if a single company offered to buy 20% or more of the company. They structured their poison pill so that they could “identify, develop and negotiate alternatives.”
- J.C. Penney. The retail giant also initiated a poison pill strategy. In 2010, Pershing Square Capital Management and Vornado Realty Trust acquired a 26% share in J.C. Penney. Afraid that they may buy out a larger stake in the firm, the retailer instituted a poison pill strategy. The terms were that if either company attempted to purchase additional shares, they would dilute their holdings with new offerings.
The Legality of Poison Pills
Poison pills have inspired controversy and a number of legal questions since they were first introduced. Arguing that they render suitors powerless, some states have made them illegal.
In the UK, poison pills are not allowed without shareholder approval, whereas other European countries are still trying to determine what the laws should be surrounding them. In Canada, poison pills are not allowed if shareholders decide they would like to allow a company to offer a proposal. In effect, Canada recognizes the right to accept a takeover bid as belonging to stockholders rather than directors.
Also, if a company does have a poison pill in place, the bidder can appeal to regulators and have the poison pill stricken. Authorities almost always side with the bidder and reverse the pill. However, a company may be allowed to continue using a poison pill if they are trying to buy time to look for competing bids.
Poison pills are a popular and effective way to fight hostile takeovers. But while they can benefit shareholders, they can also also be detrimental depending primarily upon the motivations of both companies involved. The primary drawback, perhaps, is that they give untoward power to management even when the majority of shareholders may be opposed to their use. Be cautious of corporations that limit buy-out opportunities with “shareholder rights plans,” which are often intended to limit shareholder rights in the end.
What are your thoughts on the use of poison pills to fight hostile takeovers?
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