A poison pill is a defensive strategy used by companies seeking to fend off hostile takeovers. Also known as a shareholder rights plan, a poison pill aims to deter other companies or shareholders from acquiring a target firm by driving up the price of the potential acquisition or making it exceedingly difficult to complete.
When Tesla CEO Elon Musk announced his desire to acquire Twitter and take it private in April 2022, the company quickly adopted a poison pill plan to ward off Musk’s attempted takeover. However, Twitter subsequently agreed to sell itself to Musk for $44 billion in a mega deal that stunned the financial world. We take a closer look at poison pills below and break down how they are used in the financial world.
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Hostile Takeover Definition
When a firm attempts to acquire or merge with a public company but cannot reach an agreement with the target firm, the bidding company may take aggressive steps to eventually take over the business. This is known as a hostile takeover and it can be executed in several different ways.
The bidding company can acquire a controlling stake in the target company by getting shareholders to sell their stock. This is done through a tender offer and it involves making a fixed bid that will pay shareholders an above-market-value price for their stock.
Aside from a tender offer, a bidding company can also convince a majority of stockholders to replace the company’s management with leadership that will agree to a sale. This is known as a proxy fight.
Why Poison Pills Are Used
A company resorts to a shareholder rights plan and adopts a poison pill as a way to defend against a hostile takeover. A poison pill can serve as a deterrent for a company that has its sights set on acquiring another by making the takeover more expensive or more complicated than originally expected.
For example, a target company can issue new shares of stock to all existing shareholders, but exclude the bidding company. This dilutes the bidder’s ownership stake in the target company and leaves the firm needing to acquire more shares than initially thought.
Types of Poison Pills
When a target company takes defensive measures against an acquiring firm, it has several types of poison pills it can employ. Here’s a look at three options:
Flip-in: The scenario provided above is an example of a flip-in. This type of poison pill involves the target company making new shares of stock available at a discount, but bars the acquiring firm from purchasing any.
Imagine Restaurants Worldwide, a global conglomerate of restaurant chains, seeks to buy a chain of pizzerias called Pete’s Pizza. The pizza business has been good and Pete’s Pizza is a publicly traded company with a market capitalization of $1 billion. There are currently 10 million shares of company each valued at $100. Restaurants Worldwide already owns 20% of the company, but wants to acquire a controlling stake. After Pete’s Pizza rebuffs the conglomerate’s offer to merge, its management adopts a flip-in shareholder rights plan and issues 2 million new shares of stock at a discounted price.
With more shares of Pete’s Pizza in existence, Restaurants Worldwide’s 2 million shares (valued at $83.33 per share) now comprise only 16.6% of the company. The move means Restaurants Worldwide will have to purchase more stock than it originally planned to acquire a controlling stake in Pete’s Pizza. The conglomerate decides that price is too high and moves on from the hostile takeover.
Flip-over: While a flip-in dilutes an acquiring company’s ownership stake in a target company before a potential takeover, a flip-over gives the target company’s shareholders the opportunity to purchase discounted shares from the other firm after the acquisition. This strategy dilutes the stock of the acquiring company and can be a disincentive for a hostile takeover.
Preferred Stock Plan: Another strategy the target firm can employ is to issue new shares of preferred stock to current shareholders. These preferred shares can be converted into a greater number of common shares in the event of a takeover and leave the target company’s ownership stake diluted.
A poison pill or shareholder rights plan is a defensive strategy a company can use to prevent a hostile takeover from happening. The strategy relies on issuing new shares of stock at a discounted price for all existing shareholders, except the acquiring company. This dilutes the bidding company’s ownership stake in the target firm and makes a potential takeover more expensive and complicated to carry out.
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