Poison Pill Defense

In the event of a hostile merger or acquisition, a target company has several defensive strategies at its disposal. One of the most widely used and recognized defenses globally is the poison pill. There are different types of poison pills, such as the flip-in pill, which allows existing shareholders (excluding the acquirer) to buy additional shares at a discount, diluting the acquirer’s stake, and the flip-over pill, which permits shareholders to purchase shares of the merged entity at a discounted rate after the takeover. These strategies are designed to make hostile takeovers more difficult and costly for the acquirer.

What is Hostile Merger or an Acquisition?

A hostile merger or acquisition occurs when the target company’s board opposes the acquirer. This opposition can stem from various reasons, such as the target’s shares being undervalued, concerns that the acquirer might diminish shareholder value, potential asset sell-offs crucial to the company, the likelihood of significant employee layoffs, or a cultural misalignment between the two companies.

What is Poison Pill Defense?

A poison pill is a defensive strategy employed by a target company during a hostile acquisition to deter the acquirer by making the takeover more expensive. It grants all shareholders, except the acquirer, the right to purchase shares of the target company or the merged entity at a discount. This dilutes the acquirer’s ownership percentage, requiring them to invest significantly more capital to gain control, thereby making the acquisition less attractive.

The board can implement these rights at any time, without needing shareholder approval, setting the trigger limit – typically when an entity acquires 10-20% of shares. These rights usually expire within a year but can be extended.

Flip-in vs. Flip-Over Poison Pill Defense?

There are two most common types of Poison pills – Flip-in and Flip-over:

Flip-in

Flip-in strategy is triggered when a specific event occurs, and allows all shareholders except the acquirer to buy shares of the target company at a significant discount. Key elements include:

Trigger/Event: Activated when the acquirer reaches a certain percentage of share ownership

Conversion Price: The discounted price at which shareholders can buy additional shares, regardless of the current market price

Duration: The time frame during which shareholders can exercise their rights

Flip-in Example

Woke Inc., a tech firm with valuable intellectual property, faces a hostile takeover from Hostile Inc., which offers to buy Woke’s shares at a premium. In response, Woke’s board adopts a flip-in poison pill. If Hostile acquires more than 10% of Woke’s shares, all other shareholders can buy two shares of Woke at the current market price.

In the event of a hostile merger or acquisition, a target company has several defensive strategies at its disposal. One of the most widely used and recognized defenses globally is the poison pill. There are different types of poison pills, such as the flip-in pill, which allows existing shareholders (excluding the acquirer) to buy additional shares at a discount, diluting the acquirer’s stake, and the flip-over pill, These strategies are designed to make hostile takeovers more difficult and costly for the acquirer.

*Note: It’s assumed that the new market capitalization is the sum of the old market cap plus the additional cash contributed by existing shareholders. However, this may not be entirely accurate, as the share price will be influenced by various market factors, such as the acquirer’s interest in the target company post-flip-in, the management’s ability to continue running the company, and the overall attractiveness of the target to its shareholders.

Insight: It’s clear that once the flip-in option is triggered and fully utilized by existing shareholders, Hostile’s ownership is diluted from 10% to 3.7%. What could have been acquired for $1mm in equity value now requires $1.9mm, making the acquisition significantly less appealing for Hostile.

Flip-over

Flip-over strategy is triggered by a specific event, it grants each shareholder, except the acquirer, the right to purchase shares of the merged or surviving entity at a significant discount. Unlike the Flip-in pill, this approach comes into play after the acquisition has occurred. Key elements include:

Trigger/Event: Activated when the acquirer reaches a certain percentage of shareholding

Conversion Price: The discounted price at which shareholders can buy shares of the merged or surviving entity, regardless of the current market price

Duration: The period during which shareholders can exercise their rights

Flip-over Example

Continuing the previous example, assume Hostile Inc. has acquired 10% equity in Woke Inc. and is pursuing a hostile takeover. Woke adopts a flip-over poison pill, granting each shareholder (except Hostile) the right to purchase two shares of the merged or surviving entity at the prevailing market price. If, post-acquisition, the surviving entity has 1,000,000 outstanding shares trading at $100 each, let’s explore how this impacts Hostile’s shareholders.

Insight: The flip-over strategy not only caused a drop in Hostile’s share price but also diluted its pre-flip-over shareholders’ ownership from 100% to 66.7%. This highlights the potency of the flip-over pill, as it can significantly shift control of the merged entity to the target company’s shareholders, depending on the pill’s structure.

Real Life Case Study

Hypothetical Scenarios if Twitter Had triggered a Flip-in Pill During Elon Musk’s Hostile Takeover Attempt

Elon Musk’s acquisition of Twitter serves as a prime example of a potential flip-in poison pill strategy.

Here’s a quick timeline recap:

• On April 5, 2022, Elon Musk revealed he had acquired more than 9% of Twitter’s shares on the open market. Initially, he was offered a board seat
• That plan quickly fell through, and on April 15, 2022, Twitter adopted a poison-pill strategy to prevent a hostile takeover by Musk, setting a 15% shareholding as the trigger point
• Although the deal eventually went through on April 25, 2022, when Twitter’s board accepted Musk’s offer, here’s a hypothetical scenario of what could have happened if Twitter had triggered a flip-in pill

(For detailed calculation, please refer download section)

Insight: Although the flip-in poison pill wasn’t triggered, if it had been during the hostile takeover, Musk’s shareholding could have been significantly diluted from 10% to as low as 2.5% if the share price was $70, or even down to 0.2% if the price was $5. This underscores the pill’s potency and its ability to drastically dilute the acquirer’s stake, making the acquisition far less attractive.

History of the Poison Pill:

Martin Lipton of the law firm Wachtell, Lipton, Rosen & Katz is credited with inventing the poison pill in 1980s. In one notable case, Lipton was hired by Lenox when Brown-Forman launched a hostile bid after a failed friendly merger attempt. Lenox’s board, advised by Lipton, issued a “Special Cumulative Dividend” giving shareholders the right to buy the merged or surviving entity shares at a deep discount if a merger occurred. This strategy forced Brown-Forman to increase its offer, leading to a negotiated agreement. After this successful use, many companies adopted poison pills, and by 1989, 60% of Fortune 500 firms had implemented them.

Are Poison Pills Effective?

From the Board’s Perspective

Since the introduction of the poison pill in the 1980s, it has been knowingly triggered only once, by Versata Enterprises Inc. (Gerstein, Faris, Kronsnoble, and Drewry, 2009). This rarity underscores the poison pill’s effectiveness in deterring hostile takeovers. By significantly increasing the cost and complexity of acquisition, poison pills compel the acquirer to negotiate directly with the board rather than bypassing it to reach shareholders. The pill can only be retracted with board approval, which further strengthens the company’s defensive stance and protects its autonomy.

From the Shareholder’s Perspective

Resistance from the board can drive the acquirer to increase the premium, which benefits shareholders. However, there is a limit beyond which the acquirer may walk away, reducing the likelihood of a successful takeover. The board must be aware of this balance, as higher premiums can decrease the chances of closing a deal.

Are there Limits to Using a Poison Pill?

While poison pills are effective in deterring hostile takeovers, they must be used carefully to avoid shareholder dissatisfaction, and potential market backlash.

1. Fiduciary Duty: The board must act in the best interests of shareholders. If a poison pill is seen as blocking a beneficial offer, the board could face legal challenges for violating their fiduciary duties
2. Shareholder Discontent: Shareholders may pressure the board to remove a poison pill, especially if they believe it is preventing a favorable acquisition. Shareholders can vote to replace board members who support the poison pill
3. Market Reaction: The adoption of a poison pill can sometimes negatively impact the company’s stock price if investors perceive it as a sign of the board’s unwillingness to consider valid acquisition offers
4. Proxy Fights: An acquirer can initiate a proxy fight to replace the board with directors who are more amenable to the takeover, potentially leading to the removal of the poison pill

Conclusion

The poison pill remains one of the most powerful and widely recognized defenses against hostile takeovers, offering a robust mechanism to protect a company’s autonomy. By significantly raising the cost and complexity of an acquisition, poison pills can deter even the most determined acquirers. However, while effective, these strategies come with limitations and must be implemented with caution to avoid legal challenges, shareholder dissatisfaction, and potential market backlash. A well-crafted poison pill not only defends against unwanted takeovers but also ensures that any acquisition aligns with the best interests of the company and its shareholders.

Additional Resources

Investment Banking Courses

M&A Explained

10 Largest US & European Mergers and Acquisitions in History

Asset Step Ups (M&A)