In Finance, what is a Poison Pill?

A poison pill is a financial strategy that is sometimes used in order to allow a business to prevent an undesirable event from taking place. In most instances, the approach is implemented as a means of discouraging a hostile takeover by making the company less attractive, and thus not worth the time of the corporate raiders; or increasing the amount of resources needed to acquire the company to a level that the raider finds unacceptable. There are several ways that a company can create this poison pill effect and still not cripple the business permanently.

One approach to creating a poison pill is to increase the number of shares of stock available for purchase. Along with the stock issue, shareholders are allowed to purchase the shares at below market prices. This creates a situation where the raider must be willing to pay current market prices for these new shares, assuming that any of the shareholders are willing to sell them. Depending on the number of shares issued, this may render the takeover attempt less attractive, since the potential return is decreased.

Another means of manufacturing a poison pill situation is to create what is known as an employee stock ownership plan, or ESOP. With this plan, all current shares not in the control of the raider are converted to a different class of stock and issued to employees. Plans of this type often require that in the event of an acquisition attempt, the buyer must purchase those shares from the employees at either the current market value or a pre-determined minimum prices per share, whichever is higher. Setting the minimum figure at a level that is likely to be beyond the limits of what the raider is willing to invest in the hostile takeover will easily bring the attempt to an end.

It is even possible to create a poison pill that involves the current clientele of the company that is under siege. By creating a working agreement that insures the customers will receive a significant amount of compensation in the event of a takeover, a financial burden is placed on the raider that is likely to bring the takeover attempt to an end. The terms of this agreement normally are structured in a way that protects the client from even a slight possibility that any entity that takes over the company will discontinue product lines or make any other changes that would negatively impact the business relationship.

When creating a poison pill, it is important to find the perfect balance between what is enough to discourage the hostile takeover, but not enough to create severe financial hardship for the company. For example, if shares of stock are issued to employees as part of the anti-takeover device, the company must be in a position to eventually buy those shares back, without crippling the operation over the long-term. The same is true when it comes to issuing new shares and selling them below market value to existing shareholders; the company does want to maintain its market share, honor all shareholder commitments, and still position itself to see all issued shares increase in market value. For this reason, the creation of a poison pill requires careful planning and execution, or the company will face hardships that are much worse than any hostile takeover can create.