A “poison pill” is a defensive tactic used to discourage a hostile takeover. Professor John D. Morley of Yale Law School explains how they work.
A poison pill is a tool used by corporate boards to make an acquisition intolerably expensive. The way that a poison pill works is by setting a trigger or threshold in the terms of stock ownership which, if reached or surpassed by a particular shareholder, will result in the dilution of that shareholder's interest in the company. Morley gives the example of a company that sets its poison pill trigger at 15% of the company’s stock. If a shareholder then purchases a 17% position in the company, the company may then make significant quantities of stock available for purchase to all other shareholders at a reduced price or even at no cost at all. This can both make the potential acquisition more expensive and at the same time significantly dilute the potential acquirer's share.
Professor Morley explains that poison pills are so effective that they can make takeover bit through purchase of a majority of stock an impossibility. So how can they be overcome? Generally, the only options are either to get the approval of the board by increasing the purchase price or to replace sufficient board members to permit the removal of the poison pill.
John D. Morley a professor of law at Yale Law School. His research focuses on the law and economics of organization, with a special emphasis on the regulation and structure of investment funds.
Interview with Yale Law Professor, John D. Morley
Joel Cohen ("Host"): There are few structures in the M&A world that have as dramatic a title as the "poison pill", but what exactly is a poison pill and how does it work? Today, we'll discuss it. We're joined remotely by Professor John Morley of Yale Law School. John, what is a poison pill?
Professor John Morley: Thanks for the invitation to be here, Joel. A poison pill is basically a mechanism that deters a potential acquirer from taking control of a target company. It's often called a shareholder rights plan because it works as follows: There's a provision in the company's certificate of incorporation that says if someone buys more than a certain percentage of the company's stock without permission from the company's board, then every other stockholder - not that acquirer, but everyone else - will get the right to buy a massive amount of stock in the company at a discounted price. That then dilutes the stockholder who had previously purchased it, reduces the portion of the total outstanding shares that that stockholder owns, and it also reduces the value of that stockholder's shares by sending out a bunch of shares in exchange for a cash amount that's less than what those shares were previously worth.
Host: One high-profile recent example involved Elon Musk's takeover of Twitter. At some point, he purchased equity and the Twitter board responded by enacting a poison pill. What did they do and how did it work?
Professor John Morley: They basically adopted a pill which said if any person - obviously they had Elon Musk in mind but it was worded generally - if any person acquires more than 15 percent of the voting stock of the company, the company will issue a large number of shares to every other stockholder of the company at a discounted price. That would have reduced the percentage that Elon owned and also reduced the value of those shares.
Host: So, there's actually a bit of flexibility in how the anti-takeover mechanism works. You're diluting the potential acquirer, but you could do it by issuing free equity to the other shareholders or by selling stock at a steep discount.
Professor John Morley: Yes, it can take a variety of forms and flavors. One requires all the existing stockholders, other than the acquirer, to contribute a small amount of money in order to get a large amount of shares. Sometimes they just give shares away. Sometimes the pills can be triggered at different levels by different people. If you buy stock with the intention of changing control, the pill gets triggered at a lower level of ownership than if you buy stock without the intention of changing control. These things come in a great variety of shapes and sizes.
In order to adopt a poison pill, all you need is a resolution of the board of directors. So, if you call a law firm that's experienced in handling these matters and ask them to give you a template, you can adopt a poison pill in a matter of hours. As a practical matter, that means that every company can operate as if it has a poison pill, whether or not it actually does. It's made even easier by the fact that Federal Securities Law requires any person who acquires more than five percent of the company's shares to disclose that stake soon after crossing the five percent threshold. So, a company usually gets notice that there's a shark swimming in the waters well before it needs to adopt a poison pill.
Host: In some ways, it seems unfair. I mean, if I want to buy a public company, why shouldn't I be able to buy a public company? At what purpose, when can these actually be useful for a business?
Professor John Morley: We can think about this in ways that are maybe more cynical and less cynical. The most cynical theory is that the board of directors and senior management want to keep their jobs and they know that if a hostile takeover gets completed, they'll all get fired. So, the value of a poison pill is to stop that from happening.
The less cynical view is that a poison pill is useful for giving a company time and leverage to negotiate. If an acquirer can get control by just buying up stock at the prevailing price on the New York Stock Exchange, the company doesn't really have a good way of extracting a premium that would truly reflect the full value of control.
Also, Joel, there are inevitably people other than stockholders who have made personal investments in a firm. The workers might have moved to be close to their workplaces. They might have accumulated forms of training and human capital that are specific to that firm. And maybe we want to protect the interests of those people and not just the interests of billionaires who have money to burn acquiring fancy companies that they want to play with.
Host: John Morley is a professor of law at Yale Law School. John, thanks for the time.
Professor John Morley: Thank you for having me.