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What Is a Poison Pill?

Created in the 1980s by M&A lawyer Martin Lipton, the
so-called "poison pill" is a tactic public companies use to
thwart hostile takeovers. In effect, it is an agreement adopted by a company's
board of directors that makes the target's stock prohibitively
expensive or otherwise unattractive to an unwanted acquirer. To date, no
takeover bid has ever seen a poison pill fully executed — management
teams typically have used the strategy as a deterrent and negotiation tool,
buying their company time to bargain for a better purchase price.

But shareholders often rail against the tactic, arguing that
they don't always have the right to vote on the bid, and that a
takeover bid that management finds unwanted could actually be in their best
interest. Consequently, many public companies that become acquisition targets
face the awkward decision to either appease investors or lose one of their most
effective weapons against hostile takeovers.

How It Works

Most poison-pill agreements are triggered when an outside
company or individual — think Carl Icahn, for example — acquires
enough stock to gain a controlling interest in the target
company. The term is often used as a catch-all for a variety of antitakeover
measures, but in its most common form there are two primary tactics:

Flip-over: If a hostile takeover occurs, investors
have the option to purchase the bidder’s shares at a discount, thereby devaluing the acquirer’s
stock and diluting its stake in the company.

Flip-in: Management offers shares to investors at a
discount if an acquirer merely purchases a certain percentage of the company.
The discount is not available to the acquirer, and so it becomes extremely
expensive for that acquirer to complete the takeover. Experts estimate that it
would cost an unwanted bidder, on average, four to five times more to “swallow”
a poison pill in order to acquire a target.

Although state courts have generally upheld the validity
of poison pills since the 1980s, judges have recently leaned toward limiting
their scope in order to protect shareholders. Currently, a target company can
still legally keep its poison pill in place and accept an offer from another
bidder, as long as the final acquisition price is higher than the original
hostile bid. In the mid-1980s Revlon tried to skirt this legal requirement because its directors favored a deal with a private equity firm. But the courts
eventually invalidated the company’s poison pill because Revlon
repeatedly rebuffed higher offers from a grocery chain called Pantry Pride.

Why It Matters Now

According to research firm Thomson
Financial, there are currently over 1,500 poison pills in place at public
companies today, with nearly 35 percent set to expire over the next two years.
That means that hundreds of companies will have to decide whether to placate
shareholders and let them expire, or renew them and risk angering corporate
investors and the increasingly influential private equity market. Some
companies will put the decision to a shareholder vote, but the majority don’t
require investor input for renewal of a poison pill.

Poison pills are generally on the decline in large-cap
companies, with the notable exception of Yahoo, which has one in place that
will be triggered if Microsoft or any other potential suitor buys more than 15 percent of the company without
board approval. These days, it’s smaller firms that are increasingly
taking up the strategy, both to ward off unsolicited bids and to drive up the
price of the company should a takeover become inevitable. “Small-cap
companies are more likely to perceive themselves as undervalued when the stock
market fluctuates,” says Keith Gottfried, a partner at Blank Rome LLP
who specializes in shareholder activism and corporate governance. Smaller
companies are also cheaper to acquire, especially in a downturn, which makes
the tactic more attractive to them.

Foreign companies are also turning to poison pills more
frequently, particularly in Canada and Japan, where hostile bids are on the
rise. According to Thomson Financial, overseas firms now account for nearly 70
percent of first-time pill adopters. In the U.S., hostile takeovers are fairly rare.
There have been only 12 hostile bids exceeding $20 million in value in the U.S.
since 2005. Historically, hostile bid activity decreases sharply during periods
of recession.

Strong Points

As a defensive tactic, poison pills are extremely
effective. Not only do they fend off unwanted takeover bids, but boards often
argue that the strategy gives the company an opportunity to find a more
suitable acquiring party, a so-called “white knight.”

Boards also favor poison pills for the leverage they bring
to the bargaining table. In 2003, enterprise software giant Oracle attempted to
acquire rival PeopleSoft through a $5.1 billion hostile takeover bid. But PeopleSoft’s
poison pill was set to trigger if Oracle bought more than 20 percent of the
company. After a year-long battle, PeopleSoft finally voided its poison pill
and was acquired by Oracle for $10.3 billion
— nearly double Oracle’s
initial offer.

Weak Spots

Since shareholders could gain from a
takeover, they often view management’s adoption of a poison pill as
blatant disregard of investors’ interests. “Adopting a
poison pill can really do a number on a company’s corporate
governance image,” says Jeffrey Block, associate director for
strategic research at Thomson Financial. “There is a knee-jerk
reaction in the marketplace against anything that dilutes the power of

Accordingly, in some cases investors send a clear message
that they don’t agree with management’s strategy by dumping
some of their shares. Consider
the example of oil company Tesoro: When the company adopted a poison pill in
November 2007 to defend itself against billionaire Kirk Kerkorian’s
Tracinda Corp., its stock plummeted almost 14 percent between the week before
the announcement and the week after. In
March 2008, Tesoro’s management dropped its poison pill, with CEO
Bruce Smith explaining that the company wanted to act in “the best
interests of our stockholders.”

When it comes to big
institutional investors, many companies in fact don’t have the choice
of adopting the tactic. Market giant Fidelity Management & Research,
for example, says that it “will generally vote against a proposal to adopt or approve the adoption of an
anti-takeover plan.”

How to Talk About It

Here are poison pill-related terms:

Activist shareholder: An investor who uses his
stake in a company to influence the management and direction of that company.
The rise in shareholder activism is one reason why many large companies have
eschewed poison pills in recent years due to their “shareholder-unfriendly”

“Chewable” pill: A modified
poison pill that can appease investors by permitting them to ask for a special
shareholder vote to determine whether or not a specific bid can be exempt from
triggering the pill. Such policies prevent companies from automatically
discouraging takeover bids that may be lucrative for shareholders.

Black knight: A company that makes an unsolicited,
hostile takeover bid on a target company.

White knight: A company that saves a target from a
hostile takeover by acquiring it under more favorable terms and a better price
per share.

Proxy contest: A technique used by a hostile bidder
to rally a group of shareholders and their proxies (authorized representatives)
to vote out the target company’s incumbent management and replace
them with managers who will be more likely to accept the bid.

Additional Resources

Book: Mergers, Acquisitions, and Corporate Restructurings, by Patrick A. Gaughan.

Book/CD-ROM: href="">Applied Mergers and Acquisitions, by
Robert F. Bruner.

Blog: href="">RiskMetrics Group Risk & Governance Blog

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