From Computer Business Review, a sister publication…

Poison pills, exploding pills, and flip ins. These words first joined the colorful business lexicon of Wall Street in the mid ’80s. Aggressive, corporate adventurism meant that mergers and acquisition (M&A) activity was at an all time high, and companies fearing a hostile takeover first began to ask their lawyers how they might legally defend their independence. After a year of unprecedented M&A activity in the IT sector, poison pills are just as likely to be discussed in Silicon Valley as in Wall Street. Dell, Wonderware and FTP have just amended their constitutions to include a poison pill. Many software companies who once thought that they were immune from hostile takeovers because their staff might leave under new management, are also planning to put a defense in place. Lotus Development Corp, taken over last year by IBM, attempted to use a poison pill as part of its initial defense.

Machiavellian mechanism

But how do they work? And do they work? A poison pill is designed to damage any unwelcome bidder interested in ‘swallowing’ the target company. The concept was created in the court rooms of Delaware, at the heartland of North American corporate judiciary – and has been the subject of continued refinement for more than a decade. By 1990, around 40% of companies in North America had approved some variant in their constitutions. In its simplest form, a poison pill authorizes the automatic issue of cheap shares to existing shareholders should an unwelcome shareholder build a stake up to a certain percentage of the target’s issued equity – usually somewhere between 10% and 20%. Critically, it is only the existing shareholders who can buy the new equity – which is usually priced at half the current market price per share. This simple, Machiavellian mechanism has the potential to deliver a devastating blow to the predator company. Not only does the unwelcome bidder see its percentage stake in the target suddenly reduced, but the absolute value of the investment collapses as under-priced stock floods the market. It is this modern form of poison pill – colloquially termed the ‘flip-in’ – which has become the first line of defense in any bid. A darker, rarer version is the ‘exploding poison pill’. This too triggers an issue of rights to existing shareholders. But the rights are priced so high that they would never be exercised. An additional clause in the rights document states that should the bid be successful, the shareholder can force the bidder to repurchase the rights at a substantial premium.

Improved Flavor

The flip-in remains the vanilla form, however, and in the last few months, several North American IT companies have made sure that poison pills bolster their constitutional defenses. In February, when its share price fell to an all time low of $16, Wonderware, a Windows-based industrial automation software supplier, set up a poison pill that would give shareholders the right to buy additional shares at half the market price if a bidder purchased 15% or more of the company’s stock. Lee Kim, Wonderware’s chief financial officer, believed that the pill would double the acquisition cost of an unwanted bid. FTP Software, a communications software company, set up a pill in December which it described as a measure to protect shareholders from attempts to acquire FTP on terms, or by using tactics, that could deny stockholders the opportunity to realize the full value of their investment. In the same month Dell, the PC manufacturer, set up a flip-in at the15% level. The poison pill is uniquely North American. In the UK, any attempt to use a flip-in runs counter to the principle that all shareholders must be treated equally. Indeed, the chance of using a poison pill defense in Europe is receding fast following the recent publication of the EC’s Proposal for a 13th European Parliament and Council Directive on Company Law concerning Takeover Bids. The proposal reiterates the principle of treating all shareholders equa

lly – making flip-ins impossible – and sets out to reduce the possibility of poison pill defenses. Corporate markets and corporate control, it argues, should remain unfettered by such artificial devices. There are, of course, other defenses, such as ensuring that the company remains permanently in private hands. Poison pills are, in a way, a paradox: Designed never to be used, yet they must work. The deterrent effect is key. Poison pills serve to extend the time available to the target company either to muster a defense or attract a more acceptable rival bid. At the very least, they force the bidder to enter negotiations with the target company’s board. In nearly all cases, the bidder will instigate court proceedings to have the pill legally dismantled and invite the target board to the negotiating table, on the same day. At the heart of the poison pill debate lies the question of conflict between the interests of shareholders – who are offered the opportunity to realize their investment when a bid is made – and the interests of management – who are usually faced with redundancy. What role do poison pills play in this conflict other than to serve management’s interests? There are two answers to the question, neither of which are wholly satisfactory. The first comes from recent research on the effects of poison pills in M&A activity and its outcome undertaken by the National Bureau of Economic Research, (NBER) based in Cambridge Massachusetts. In the opinion of the NBER, poison pills could not explain the decline in levels of corporate activity between the late ’80s and the early ’90s. It was other, structural and economic effects which were to blame, said the NBER. In other words, poison pills do not affect the number of takeovers. The second factor is that the legislation underpinning poison pills, while being complex and mature, is only partial. It is perfectly legal for a board to create a poison pill and often without shareholder approval – but this does not mean that the courts are obliged to uphold them. That will only follow if the court – assuming a bidder has sued to remove the pill – believes that the pill exists more to serve the interests of the board than the shareholders. Pills very rarely survive the courts. As a result, proponents of poison pills argue that they do not deter M&A activity or dilute shareholder value. On the contrary, by giving a defending management additional time, bidders are usually forced to bid higher in a quid pro quo trade off for the redemption of the poison pill. Shareholders are, maybe, the real winners.