What Is a Poison Pill?

Poison Pills Explained

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A poison pill is a tactic used to prevent hostile takeovers and acquisitions. In most cases, poison pills, when triggered, dilute the value of each share to make it more difficult for a bidder to take control of a company in an acquisition. 

Poison pills were more common in previous decades, but only a small percentage of companies have them today. While they can be effective in preventing hostile takeovers, they can also be harmful to investors.

Definition of a Poison Pill

A poison pill, also known as a shareholders-rights plan, is a defensive strategy that companies use to prevent hostile takeovers and acquisitions. A hostile takeover is when one company acquires another—typically by going directly to the company’s shareholders or fighting to replace management—to get the acquisition approved. The poison pill makes the company less attractive to hostile buyers by increasing the price, and either prevents the takeover or creates economic consequences for the buyer.

The term poison pill comes from actual, tangible poison pills that members of the military would have on hand during raids or missions. Agents carried pills filled with legal substances such as cyanide, which they were to take in case of capture.

The concept of poison pills for corporations was created in 1982 by Martin Lipton, a prominent corporate lawyer. These types of defensive tactics then gained popularity after a 1985 Delaware Supreme Court ruling, Moran vs. Household International Inc., which upheld the use of shareholder-rights plans.

Poison pills were significantly more popular during the 1980s and 1990s, partially due to the high number of hostile takeovers during those decades. In 1988, for example, there were about 160 unsolicited takeover bids for U.S. companies. Over the past several decades, these provisions have become less popular, many of them expiring without being renewed.

Leading up to the pandemic, hostile takeovers had been on the rise. Given the uncertainty created by COVID-19, many companies instated poison pills. From April 2019 to April 2020, 40 companies have adopted poison pills, both new or extending existing ones. 

  • Alternate name: Shareholders-rights plan

How A Poison Pill Works

A hostile takeover takes place when one company acquires another without approval from the target company’s management or board of directors. Instead, the acquiring company goes directly to the shareholders to either purchase their shares or convince them to support the sale by voting for board members who will approve the deal. The goal of a poison pill is to prevent these hostile takeovers or create severe financial consequences in case one takes place. 

A poison pill is “triggered” when an acquiring organization obtains (or in some cases, announces its intention to obtain) a certain percentage of a company’s shares. Traditionally, poison pills were triggered when a hostile buyer obtained between 30% and 50% of shares, but more recently, the threshold is much lower, around 10%.

There are several different types of poison pills. One type of poison pill gives all shareholders except for the hostile bidder the right to purchase additional shares at a discounted rate. This move dilutes the hostile bidder’s shares, making a hostile takeover more expensive and less attractive.

Imagine that a publicly traded company has 100 outstanding shares, which currently trade for $10 per share. A hostile bidder has begun buying up as many shares as possible, offering current shareholders a premium of $15 per share.

Once the hostile bidder obtains a certain number of shares—let’s say 30, for the purposes of this example—the poison pill is triggered. The company allows all shareholders, except for the hostile bidder, to purchase additional shares at a discounted rate. Shareholders can buy these shares at a discount rate of $7. Because of the new shares, the hostile bidder now owns significantly less than 30% of the company’s shares. Through the poison pill, it becomes more difficult and expensive for them to successfully complete their hostile takeover.

Types of Poison Pills

There are two primary types of poison pills that companies may adopt to prevent a hostile takeover.

  • Flip-In Poison Pill: Triggers after a hostile bidder acquires a certain percentage of shares and gives all shareholders, except for the hostile bidder, the right to purchase additional shares at a discount. This dilutes the shares and makes the takeover less attractive.
  • Flip-Over Poison Pill: Triggers after a merger and allows shareholders to purchase shares in the acquiring company at a discounted rate. This discourages hostile bidders who may fear the value of their own companies being affected.

The two types of poison pill plans can be adopted at the same time, working together to deter potential acquirers. 

Alternatives to Poison Pills

A poison pill is the most common defensive tactic against hostile takeovers, but it’s not the only one companies adopt. There are several other strategies a company might use to prevent a hostile takeover.

  • Pac-man defense: A target company purchases shares in the hostile bidder’s company, attempting their own takeover. This puts the acquiring company in an unfavorable situation and may discourage them from pursuing the hostile takeover to save their own company. This method works best when the companies are of similar size.
  • Golden parachute: This type of contract guarantees benefits for a target company’s executives who are let go as the result of a successful hostile takeover. These contracts can be expensive and, therefore, deter people against hostile takeovers. 
  • Crown jewel: A company sells its most profitable assets, making it less attractive to prospective hostile bidders. Unfortunately, it also reduces the company’s value and can cause long-term damage. In some cases, the company may sell its assets to a friendly third party who agrees to sell them back when the hostile bidder gives up.

Pros and Cons of Poison Pills

    • Deters a hostile takeover
    • Prevents any shareholder from taking too much control

    • Dilutes the shares of all shareholders
    • Potentially expensive for shareholders
    • Prevents acquisitions that could be positive for shareholders

Pros Explained

  • Deters a hostile takeover: The primary goal of a poison pill is to discourage and prevent hostile takeovers, which could be detrimental to both the company and its shareholders.
  • Prevents any shareholder from taking too much control: Poison pills can help to maintain a democracy of sorts in a corporation. This is because they prevent any one shareholder from consolidating too much control.

Cons Explained

  • Dilutes the shares of all shareholders: Issuing new shares doesn’t just dilute the shares of the hostile bidder—it also dilutes the shares of existing shareholders.
  • Potentially expensive for shareholders: When a poison pill is triggered, investors must spend money to buy additional shares to maintain their percentage of ownership within the company.
  • Prevents acquisitions that could be positive for shareholders: A company’s executives may be inclined to support a poison pill to help them maintain control. But some hostile takeovers can actually be positive for investors and increase share value.

What It Means for Individual Investors

Poison pills aren’t nearly as common as they once were. As of April 12, 2020, just 2% of firms in the S&P 500 had a poison pill provision in place. This still does not guarantee a poison pill is actually being used—that is far rarer. However, on the off chance that a company you hold shares in does swallow the poison pill, then you would be faced with the decision to either purchase additional shares in the company or see your stake in the firm diluted. 

Key Takeaways

  • A poison pill is a defensive tactic that corporations implement to prevent or discourage a hostile takeover.
  • When triggered, a poison pill typically allows all shareholders, except for the hostile bidder, to purchase additional shares in a company at a discounted rate. This dilutes the hostile bidder’s ownership.
  • A less-common type of poison pill is triggered after an acquisition takes place and allows shareholders to purchase shares in the acquiring company at a discounted rate.
  • As of April 12, 2020, only 2% of companies in the S&P 500 had poison pills in place.
  • Poison pills can be effective at preventing hostile takeovers but may be harmful to investors, as they dilute their shares and prevent acquisitions that could actually help investors.