What Exactly is a "Poison Pill" and How Does it Apply to the Stock Market?

You may have been watching CNBC one day and heard the term "poison pill" being discussed. You have probably figured out that it somehow involves one company taking over another, but you aren't sure as to what it exactly means.

The term "poison pill" goes back to World War II. Nazi spies would carry "poison pills" around with them. If they were ever captured, they would ingest the "poison pill" (usually cyanide) and kill themselves rather than being interrogated. The enemy would capture the spies, hoping to extract some helpful information - instead, the spies killed themselves and no helpful information was offered up.

So how does this relate to the stock market?

Let's say that we have two companies. Big Company, Inc. and Smaller Company, Inc. Big Company has announced plans to acquire Small Company, Inc. via a hostile takeover. Small Company, Inc. rejects the bid, and tells Big Company, Inc. that it doesn't want to be sold.

Big Company, Inc. states publicly that it is contemplating a higher bid and will actively look for ways to make this deal go through, including soliciting support of shareholders directly and looking to make changes to the Board of Directors.

Small Company, Inc. wants to make it as difficult as possible for Big Company, Inc. to acquire them, so they look to make use of "poison pills". A "poison pill" is a way for the smaller company to make it as difficult as possible (and as expensive as possible) for the large company to acquire them. "Poison pills" would include:

-Small Company says that its stock options will immediately vest if they are taken over

-Small Company increases the amount of debt that it has

-Small Company adds to its charter a stipulation that will give their shareholders the right to sell at an increased price if an outside company or person acquires a certain % of the company (usually one third).

-Small Company purchases a company of its own, thus complicating any deal for Big Company, Inc.

There are a number of other "poison pills" that can be used as well.

Basically the "poison pills" are used when one company does not want to be acquired by another, and makes it as difficult and expensive as possible for the bidding company to acquire them. That's a "poison pill".

Filed under: Stock Market Education | General Knowledge