The shareholder rights plan, known as the “poison pill”, is a specialized tactic that a board of directors employs to defend their corporation from being taken over. The poison pill strategy typically involves making the company more difficult to acquire or less attractive. This effectively prevents or at least discourages people, like investors, competitors, or other acquirers, from gaining near-total control without any negotiation.

Lawyer Martin Lipton of Wachtell, Lipton, Rosen & Katz created the poison pill strategy in 1982 in response to hostile takeovers and corporate raiders that were so prominent in the business sector at that time. The increase in hostile takeovers, in which acquirers attempted to take over companies against the wishes of their management, was motivated by short-term profits. Lipton wanted to give boards of directors more leverage in negotiating with potential acquirers and defend the integrity of their company.

The poison pill is used when acquirers attempt to accumulate an extremely dominant stake in the company and overpower other shareholders without the board’s consent. Owning enough shares to have the biggest stake in the company often means controlling interest and more voting rights, which becomes unfair to other shareholders. The poison pill sets a quota for shares that should be surpassed. For example, the poison pill commonly limits shares to 15% or less. This limit is established to lessen the discrepancy of ownership between shareholders.

The term “poison pill” insinuates a poisonous burden is placed on acquirers. How does this happen? To execute the poison pill strategy, the company’s board of directors issues rights to existing shareholders. If the set quota for shares is surpassed, other shareholders may buy additional shares at a heavy discount. This discourages potential acquirers from going any further because the potential takeover is more expensive. By making the acquisition unfavorable or even dangerous to go through with, the takeover becomes “poisonous” to the acquirer.

There are many advantages to using the poison pill. The tactic prevents majority takeover by minority interests. The poison pill also prevents the company from being sold at an undervalued price. This means it may also raise the market value of the target company, allowing it to be acquired at a higher price with consent later on. Additionally, by preventing a change in ownership of a company, the poison pill maintains stability and may preserve existing corporate culture.

While the poison pill can be effective in deterring hostile takeovers and does have its advantages, the tactic is often controversial. This is because it could be seen as protecting the interests of company management over the interests of the shareholders. The effectiveness of the poison pill also may vary depending on the legal and regulatory environment.

The poison pill is just one of many defensive plays used by companies to resist hostile takeovers and is widely used today. The strategy is often a strong way for companies to appropriately respond to a credible threat.