What it is:
A poison pill is a strategy that tries to create a shield against a takeover bid by another company by triggering a new, prohibitive cost that must be paid after the takeover.
How it works (Example):
There are many poison pill strategies that have been used by companies against hostile takeovers and corporate raiders. For example, offering a preferred stock option to current shareholders allows them to exercise their purchase rights at a huge premium to the company, making the cost of the acquisition suddenly unattractive. Another method is to take on a debt that would leave the company overleveraged and potentially unprofitable.
Some companies have created employee stock ownership plans that vest only when the takeover is finalized. In addition to a dilution of the stock value, such employee benefits may result in an employee exodus from the company leaving it without its talented workforce (which is often one of the drivers of the acquisition).
Another example is to offer a series of golden parachutes for company executives. This could also make the takeover of the company prohibitively expensive the buyer had planned to replace the top management.
Finally, one non-financial method of a poison pill is to stagger the election of the board of a company, causing the acquiring company to face a hostile board for a prolonged period of time. In some cases, this delay in gaining control of the board (and therefore the votes necesarry to approve certain key actions) is a sufficient deterrent for a takeover attempt.
An extreme implementation of a poison pill is called a suicide pill.
Why it Matters:
Poison pills raise the cost of mergers and acquisitions. At times, they create enough of a disincentive to deter takeover attempts altogether. Companies should be careful, however, in constructing poison pill strategies. As a strategy, poison pills are only effective as a deterrent. When actually put into effect, they often create potentially devastatingly high costs and are usually not in the best long-term interests of the shareholders.