Question

3. Do some Internet research to find out what it means for a company to create a “poison pill”? Why might a company do that? Some economists think poison pills should be illegal. What is their rationale?

Answer 1

A poison pill is a defense against a "hostile" takeover attempt by someone to gain control of a company against the current management's wishes. Corporate-structured companies are the most susceptible to hostile takeovers, as control of these companies is focused on stock ownership. You will manage the company if you purchase a majority of voting shares in a company or get a majority of the shareholders to vote according to your instructions. This is one reason why businessmen starting companies and selling stock to raise money are careful to hold in their own hands a controlling interest.

Say your company is set up as a corporation with a stock outstanding of 100,000 shares. You have sold or given other people 60,000 shares, who are content to let you run the company. With 40,000 shares, you're still the biggest shareholder and you run the company. Now say someone comes along, and the other shareholders start buying out. If that individual can accumulate 50,001 shares, then he will be the owner of the majority and can push you out. You could try to head him off by taking out 10,001 shares on your own or you could build a poison pill to get the board to accept it before it's too late.

Anyone who owns the business also bears the responsibility to pay the company's debt. When a corporation has a lot of debt, it may establish a poison pill simply by stating that in case the board of directors is changed, the largest shareholder shifts, or any other triggering event happens, all the debt is payable immediately. This may be enough in itself to discourage a takeover. The company will even go on a borrowing binge, taking on a huge amount of debt. A major downside to the above approach is evident: the business is now saddled with more debt even though the pill is successful.

The most popular poison pills involve issuing new stock, with a view to making buying enough stock much more costly to take leverage. One plan is to launch a new form of preferred stock that would become "redeemable" meaning stockholders will only be able to exchange their shares for cash following a takeover. This generates a huge financial liability which can discourage a takeover. Alternatively, in the case of an attempted takeover, each preferred share may be structured to convert to several common stock shares, which would immediately dilute the person's interest attempting to execute the takeover. Another choice is to sell existing shareholders new stock at a deep discount, increasing the amount of outstanding shares and making it far more difficult to acquire a majority stake.