Why Is a Shareholder Rights Plan Called a "Poison Pill?"

Shareholder Rights Plans and Poison Pills

Faced with the prospect of a hostile takeover by an activist individual investor, another company, or an investor group, a corporate board might adopt a defensive strategy called a shareholder rights plan, or poison pill.

The goal is to make the accumulation of shares beyond a defined limit financially unpalatable. Hence the poison pill nickname for the tactic.

Such plans discourage the unwelcome accumulation of company stock above a threshold set in the shareholder rights plan by promising to dilute an activist buyer's stake with discounted share sales to the other shareholders.

Key Takeaways

  • A poison pill strategy is another name for a shareholder rights plan.
  • The poison pill name derives from the idea of making accumulating a controlling number of shares undesirable for the acquirer.
  • A poison pill is designed to discourage a major acquisition of shares and a company's hostile takeover by an individual or entity.
  • Once activated, the strategy allows shareholders, with the exception of the acquiring party, to buy additional shares of company stock at a highly discounted price.
  • The point of a poison pill defense is to make the cost of acquiring the company more than the payoff.

Advantages of a Poison Pill Plan

  • Introduced in 1982 as hostile takeovers started shaking up corporate boardrooms, shareholder rights plans have proven effective as a delaying tactic in the face of takeover interest. However, they're seldom the long-term answer to activist pressure or merger interest.
  • A poison pill defense could help a company whose share price has suffered a short-term decline resist a vulture bid from a potential acquirer seeking to take advantage of a temporary discount. Market declines at the outset of the COVID-19 pandemic led hundreds of U.S. companies to adopt shareholder rights plans for that reason.
  • Poison pill plans can play a role in negotiating a more attractive price from a suitor.

Twitter adopted a poison pill defense in 2022 once Elon Musk acquired more than 9% of the company's stock. The company wanted to prevent any person or entity from gaining control of Twitter without compensating all shareholders appropriately. The accumulation threshold was 15%.

Disadvantages of a Poison Pill Plan

  • By discouraging a motivated buyer from buying more company stock, a shareholder rights plan is likely to leave a share price lower than it would be otherwise, at least in the short run.
  • Poison pills can also shield entrenched and underperforming company managers from shareholder efforts to replace them. The good news is that since shareholder rights plans are adopted by company boards, replacing a board in a proxy contest can result in the elimination of a poison pill.
  • Because poison pills discriminate against activist buyers and restrain trading in a company's stock, they typically require justification, and often have sunset provisions.
  • Shareholder rights plans cannot dilute the stakes acquired before they were adopted, so they can't reverse the accumulation of shares by activists or potential acquirers.

Example

An example of a poison pill defense occurred in 2012, when the board of Netflix, Inc. (NFLX) adopted a shareholder rights plan days after investor Carl Icahn acquired a 10% stake in the company.

Netflix's poison pill defense created a dividend distribution of one Right for each outstanding share of Netflix common stock. 

Further, it stipulated that in the event of any new acquisition of 10% or more of Netflix's common stock by a person or group, or 20% or more by an institutional investor, that "each Right will entitle its holder (other than such person or members of such group) to purchase, at the Right’s exercise price (subject to adjustment as provided in the Plan), a number of shares of Netflix’s common stock having a then-current market value of twice the exercise price." 

The point of the poison pill, or Rights Plan, was to maintain Netflix's shareholders' rights and the company's ability to determine what was in the best interest of those shareholders and the company.

It also made clear that the plan wasn't intended to stop a merger or other type of corporate change that could be of value to shareholders and that the company's board of directors approved of.

Is a Poison Pill a Good Thing?

Yes, in that it provides a company with a defense strategy against hostile takeovers by activist investors.

Are Poison Pills Good for Shareholders?

In certain ways. For example, if activated, shareholders can buy additional shares at an attractive discount. But, because stock values become diluted, ownership percentages are affected. A shareholder will have to buy even more shares to maintain their particular level of ownership.

Why Is the Strategy Called Poison Pill?

The term relates to making the accumulation of a certain number of shares financially unappealing (due to the penalty the acquirer suffers). From the company's standpoint, it also ties in with the idea of swallowing poison to avoid being captured.

The Bottom Line

A poison pill defense strategy is another name for a shareholder rights plan. It involves the sale to shareholders of price-discounted shares to protect a company from a hostile takeover by an activist individual investor, company, or institutional investor.

Its purpose is to discourage any one shareholder from acquiring a controlling amount of stock and to give the company time to consider any offer and what actions it might take to maximize shareholder value.

Article Sources
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  1. Harvard Law School, Forum on Corporate Governance. "Renewed Interest by Public Companies in NOL Rights Plans."

  2. The New York TImes. "What Is a 'Poison Pill' Defense?"

  3. CISION. "Twitter Adopts Limited Duration Shareholder Rights Plan, Enabling All Shareholders to Realize Full Value of Company."

  4. The National Law Review. "Poison Pills in the Wake of COVID-19: A Refresher on Terms and Variations of Shareholder Rights Plans."

  5. Netflix. "Netflix Adopts Stockholder Rights Plan."

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