Poison Pill: A Defense Strategy and Shareholder Rights Plan

What Is a Poison Pill?

Poison pills are a defense strategy used by the directors of a public company to prevent activist investors, competitors, or other would-be acquirers from taking control of the company. There are several types of poison pills—the most common type is the flip-in, executed by issuing more shares to all shareholders except the offending acquirer, thus lowering the amount of control they have or could obtain.

Another goal is to force the entity trying to acquire the company to negotiate with the company's board for a buyout price. Courts have upheld poison pills as a legitimate defense by corporate boards, which are not obligated to accept any offer they do not deem to be in the company's long-term interest.

How Poison Pills Work

The poison pill is a tactic companies use to deter takeovers by unwanted companies. Often called a shareholder rights plan, it is meant to frustrate creeping acquisitions of control, in which the acquirer seeks to accumulate a controlling or dominant stake without negotiating with the board or offering the same deal to every shareholder.

Because many shares come with ownership and voting rights, it is possible to own enough to purchase a controlling amount of shares with voting rights. So, if one entity owns the right amount of shares, their votes weigh more than those with fewer shares.

To prevent this, the potential target creates a provision that prevents hostile takeovers by establishing a share ownership limit. This provision may specify that if a single entity or person acquires a stake of 15% or more, the company implements a share issuance or other measure that makes the hostile action ineffective or undesirable.

In a flip-in, all other shareholders become eligible to acquire additional shares for a large discount or free. The party with the 15% stake is excluded from the stock issuance. This increases the number of outstanding shares and dilutes that party's stake, thus averting the takeover.

Special Considerations

Proxy advisory firms Glass Lewis and International Shareholder Services traditionally opposed poison pills because of their potential to entrench managers unresponsive to shareholders.

As of 2022, ISS guidelines called for poison pills to have a term of no more than three years and a trigger of no lower than 20% of shares outstanding. Glass Lewis generally opposes poison pills, with case-by-case exceptions for those limited in scope and motivated by a particular threat or objective.

Advantages and Disadvantages of a Poison Pill

Advantages

A company's board has a fiduciary duty to protect the interests of all shareholders, while an outsider seeking control may only wish or need to satisfy a minority to gain effective control through a tender offer. A poison pill helps prevent majority control takeovers that disregard the interests of minority shareholders.

It also discourages vulture bids seeking to take advantage of a temporary decline in a share price. For instance, market declines at the outset of the COVID-19 pandemic led hundreds of U.S. companies to adopt shareholder rights plans.

Companies with poison pill defenses have tended to garner higher takeover premiums than those without them. Industrial gasses supplier Airgas, which deployed a poison pill to resist a hostile takeover by rival Air Products and Chemicals (APD) in a landmark legal battle, sold four years later to Air Liquide for more than twice as much as Air Products offered.

Disadvantages

By discouraging a motivated buyer from buying more company stock, a poison pill will likely leave a share price lower than it would be otherwise, at least in the short run.

Poison pills can also shield underperforming board members from shareholder efforts to replace them. The good news on that score is that replacing a company board in a proxy contest can make a poison pill disappear if the new board chooses to do so.

Because poison pills discriminate against activist buyers and restrain trading in a company's stock, they typically require justification and often have sunset provisions. A sunset provision is a clause that expires automatically at a certain date.

Types of Poison Pills

Most poison pills are triggered by the accumulation of a company stake above a preset threshold. These are known as flip-in shareholder rights plans, in contrast to the seldom-used flip-over ones. This type of poison pill is just like a reverse takeover. It occurs when a company allows itself to be acquired by another public company and then lets shareholders buy shares of the acquirer at a discount.

A dead-hand or slow-hand poison pill limits a future board's ability to remove that provision by specifying that it can only be canceled by a board majority consisting of current directors or the successors they choose. Delaware, the corporate domicile state of two-thirds of Fortune 500 companies and most recent initial public offerings, bars dead-hand poison pills, while Georgia and Pennsylvania courts have upheld them.

Examples of Poison Pills

The poison pill tactic has been around since the 1980s when it was devised by New York law firm Wachtell, Lipton, Rosen, and Katz amid a wave of hostile takeover and greenmail attempts by corporate raiders since rebranded as activist investors. Courts have ruled that poison pills are a legitimate defense against such attempts to circumvent a company board's prerogatives.

X (Formerly Twitter)

In early April 2022, Elon Musk threatened social media giant X with a hostile takeover by disclosing that he purchased 9% of the company's shares.

X adopted a poison pill provision to prevent the takeover in mid-April 2022. It used 15% as its ownership threshold, which prevented anyone from taking over the company without bargaining for a fair value. By the end of April, the company agreed to a buyout by Elon Musk.

Musk ended up purchasing the company in October 2022 for $44 billion.

Papa John's

In July 2018, the board of restaurant chain Papa John's (PZZA) voted to adopt a poison pill to prevent ousted founder John Schnatter from gaining control of the company. Schnatter, who owned 30% of the company's stock, was the company's largest shareholder.

To deter a takeover attempt by Schnatter, the board adopted a poison pill expiring after a year that would permit the company to sell its stock to shareholders for half its market price if Schnatter and his affiliates increased their stake to 31%, or if anyone else amassed a 15% stake. As with all poison pills, those triggering the provision would not be allowed to buy stock on the same discounted terms, effectively diluting their stake.

When announcing the poison pill's adoption, the company stated,

"Adoption of the Rights Plan is intended to enable all Papa John’s stockholders to realize the full potential value of their investment in the company and to protect the interests of the company and its stockholders by reducing the likelihood that any person or group gains control of Papa John’s through open market accumulation or other tactics without paying an appropriate control premium."

Schnatter filed suit over some of the poison pill's provisions, settling it the following year along with other litigation against the company. He reduced his stake to less than 4% by 2020.

Netflix

In 2012, Netflix (NFLX) announced a poison pill days after billionaire investor Carl Icahn and affiliates disclosed a stake of nearly 10%. The poison pill promised to dilute the stake of anyone acquiring more than 10% of the video streaming service provider by allowing other shareholders to purchase two shares for the price of one.

In disclosing their stake, Icahn affiliates suggested "Netflix may hold significant strategic value for a variety of significantly larger companies," adding they were "considering ways for [Netflix] to maximize shareholder value."

The Icahn funds criticized the company's adoption of a poison pill in an updated securities filing. Any "poison pill without a shareholder vote is an example of poor corporate governance, and...the pill Netflix just adopted is particularly troubling due to its remarkably low and discriminatory 10% threshold," they said.

Icahn's stake was later reduced, and eventually, it was sold for a hefty gain.

The Bottom Line

Poison pills are provisions companies include in their stock issuances that prevent anyone from gaining a controlling stake. They usually have share ownership thresholds set that trigger the issue of more shares to stockholders for a discount or for free. Thus, poison pills reduce a would-be acquirer's stake in a company, forcing them to negotiate with the board for ownership rather than forcing their way in through stock ownership.