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Finance and Trading Terms Explained: What Is a Poison Pill?

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Whether you've never heard of it or just need a refresher, we've got the lowdown on this business term.

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Even professional traders and investors can't always speak the language of colleagues working in a different segment of the financial world. With that in mind, we've introduced this weekly column, looking at one esoteric or potentially misunderstood finance or trading term every week, from "contango" to the "head-and-shoulders pattern." This week, we'll be going corporate and looking into the term "poison pill."

What Exactly Is a Poison Pill?

"Poison pill" is a colloquial term for a shareholder rights plan, a tactic that can be used by the board of directors of a company to thwart unwanted takeover bids by making the company appear unattractive to the business or investor behind the takeover.

There are mainly two different ways that this is done. David Bakke of Money Crashers helped explain them to us:

One is known as a "flip-in," whereby current shareholders (besides the company or individual attempting the takeover) are allowed and encouraged to purchase extra shares of the organization at a reduced price. The other is called a "flip-over," which allows existing shareholders to purchase the acquiring company's stock at a reduced price after the takeover is complete.

In the flip-in scenario, shareholders gain the right to buy discounted shares before the takeover, when the acquirer passes a certain threshold of outstanding shares (which is generally between 20% and 50%). If the acquirer does trigger the flip-in poison pill, it risks a dilution of the target company shares, which will make the acquisition look a lot less valuable than it did before. Therefore, the threshold level set to trigger the flip-in creates a ceiling on the amount of shares that a potential acquirer can purchase before risking price devaluation of the target company.

In the flip-over scenario, a common stock dividend is given to shareholders in the form of the right to acquire company stock under market value. Directly following a hostile takeover, these rights would "flip over" and give current shareholders of the acquired company the ability to purchase shares of the acquiring company at a discount. Effectively, the shares of the acquiring company would be diluted and see their price devalued.

There are other variations on the poison pill, including the preferred stock plan, the back-end rights plan, and the voting plan, but they're all similar to the basic flip-in and flip-over strategies.

In all variations, the primary goal of a poison pill is to force a bidder to negotiate with the board of the target company, not its shareholders. This has two intended effects: to give the target company's management time to find competing offers and to maximize shareholder value due to a higher cost of acquisition (studies have shown the companies with poison pills receive higher takeover premiums than those without).

When Did the Term Originate?

"The term originated from a lawyer named Martin Lipton, who coined the phrase in 1982," says Bakke. "It was during this time frame that hostile takeovers were rather rampant." Corporate raiders, such as the illustrious Carl Icahn (pictured), began a wave of unwanted, forced acquisitions, and corporations needed a way to protect themselves. The term refers to pills that spies have taken throughout history to kill themselves rather than be subjected to interrogation.

As companies began to employ shareholder rights plans, the legality of this corporate defense was questioned. In 1985, in the case of Moran vs. Household International, the Delaware Supreme Court paved the way for even more use of these tactics by upholding the poison pill as a legal and valid device for defending against hostile takeovers. Despite being legal in the US, the poison pill isn't allowed everywhere: The tactic is illegal in the United Kingdom, for example.

Case Study: The Netflix Poison Pill 

In 2012, Netflix (NASDAQ:NFLX) utilized a flip-in poison pill to ward off none other than Icahn. Just days after Icahn disclosed a 9.98% stake in the company and said he was considering a hostile takeover, the board adopted a shareholder rights plan with an unusually low threshold of 10%. With the plan, the company distributed one right per common share. Each right allowed a shareholder to buy 0.001% of a new preferred share at the price of $350 per right. Of course, these rights could only be exercised if Icahn acquired more than 10% of the company without board approval. Meanwhile, the plan allowed institutional investors to acquire a stake of up to 20%.

Icahn Capital responded, "Any poison pill without a shareholder vote is an example of poor corporate governance, and ... the pill Netflix just adopted is particularly troubling due to its remarkably low and discriminatory 10% threshold." (Read more about the Netflix poison pill here.)

Since Icahn announced his 9.98% stake, the company's stock price has gained over 390% in value. In fact, Icahn sold 3 million of his Netflix shares in October 2013 for a profit of about $800 million.

Arguments Against Poison Pills

One of the main arguments against the use of poison pills is that they can perpetuate the existing management of a company to the detriment of shareholder interests. In 2008, Microsoft (NASDAQ:MSFT) made an unsolicited offer to buy Yahoo (NASDAQ:YHOO) for $44.6 billion, or $31 per share. Jerry Yang, then CEO of Yahoo, asked for $37 per share, or else he would make the takeover as difficult as possible (Yahoo had a shareholder rights plan in place since 2001).

Microsoft countered with $33 per share but got nowhere, and the deal fell through. Analysts said that even the $33-per-share price was too expensive, and that Yang hadn't been bargaining in good faith. This led to several lawsuits from shareholders, as well as a proxy fight with -- you guessed it -- Icahn, who owned just under 5% of Yahoo at the time. The failure of the deal sent Yahoo stock into a free fall; Yang faced resentment from the media and shareholders that led to his resignation. 

Of course, Yahoo is currently trading at $33.81 and was higher than $40 per share earlier this year. Now Yang is likely feeling vindicated, as it seems his hard bargaining with Microsoft was at least somewhat justifiable (given, among other factors, how valuable the company's holding in Alibaba has proven to be -- Yang was one of the main figures responsible for Yahoo buying a 40% stake in the Chinese powerhouse in 2005).

Follow me on Twitter: @JoshWolonick and @Minyanville

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