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Don't Swallow the Poison Pill

By Dan Caplinger - Updated Nov 15, 2016 at 5:09PM

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Corporate takeovers are often profitable for investors, so why stop them?

In case you haven't noticed, merger-and-acquisition activity in the stock market is back on the upswing. Just this past Monday, LSI Logic (NYSE:LSI) announced its intention to purchase Agere Systems (NYSE:AGR) in a stock trade that priced Agere's shares at a 25% premium to their previous trade. Agere rose substantially on the news, and even after falling back in recent days, it was still up more than 10% since the announcement.

Takeovers among public companies often involve paying premiums for shares so as to induce the target company's management and shareholders to agree to the deal without a fight. These premiums can result in big profits for investors who happen to own the stock when a prospective deal is announced.

Given the benefits that shareholders reap when a potential acquiring company expresses interest in buying out their shares, you may not find it obvious why a company might put measures in place to deter acquisitions. Even with so-called hostile takeovers, in which the target company's executives actively resist an acquisition attempt, shareholders can cash in with a quick profit. Yet some companies still use strategies geared toward avoiding unwanted attention from potential acquirers. These strategies are collectively known as poison pills, because they make it difficult for someone who wants to acquire a company to do so without the permission of company management.

The basics of poison pills
There are actually several different methods that companies can use to make them less attractive takeover candidates. With a standard poison pill, a company's board of directors passes a resolution that grants existing shareholders the right to receive additional shares of stock in the company if any one person or entity purchases more than a small fraction of the outstanding shares of the company. Typically, the percentage of ownership used as a threshold is set at a fairly low level, such as 10%.

If someone acquires enough shares in the company to meet the threshold, then the rights of other shareholders to obtain new shares immediately takes effect. This has the net result of diluting the potential acquirer's percentage ownership in the company. For instance, if a particular company sets up a poison pill that takes effect if someone buys 10% of the company's stock, and the terms of the poison pill allow existing shareholders to obtain an additional share for every share they currently own, then the potential acquirer's ownership interest in the company would be diluted by about one-half if the poison pill were triggered. Theoretically, a company could issue so much additional stock that an acquirer could never gain a controlling interest. At the very least, poison pills force acquirers to spend more than they might otherwise have to pay to buy out a company's shares.

In practice, a poison pill is rarely triggered. Because the board of directors can cancel the poison pill, potential acquirers seek the agreement of a company's board as an initial step in a takeover bid. As a deterrent to hostile takeovers, poison pills serve their purpose well.

Are poison pills good?
To determine whether the use of poison pills is beneficial to a company, the first thing you have to realize is that there are several different classes of individuals with stakes in what happens to a potential takeover target. Shareholders have an economic interest in maximizing the value of the company's shares. Members of the board of directors have a fiduciary duty to the shareholders who elected them, but they also often have their own financial stakes in the company. Similarly, corporate executives may stand to gain or lose substantial amounts of money and benefits depending on the outcome of a takeover bid.

For instance, Richard Fuld, the head of Lehman Brothers (NYSE:LEH), was reportedly given options 10 years ago for 2.5 million shares of stock, currently worth about $190 million, that would vest only if Fuld succeeded in selling the company. Regular company employees, who may have little or no ownership in their employer, often stand to lose from takeovers, as many acquiring companies proceed to eliminate unnecessary workers whose functions become duplicated when the acquirer's current employees already do the same job. Company customers may gain or lose depending on the impact of the acquisition on competition within the industry, as well as the quality of the newly merged organization's products.

For a company's board of directors and executives, poison pills are uniformly good. They grant company management the leverage to define the terms of any takeover in a manner that conforms to their wishes. Whether these terms primarily benefit shareholders, employees, or the corporate managers themselves depends on the integrity of the managers in fulfilling their various responsibilities to shareholders, employees, and customers.

Missing out on the long term
Shareholders, on the other hand, can find both pros and cons in poison pills. On one hand, anything that deters potential acquirers from making bids for shares at a premium effectively takes money out of the pockets of shareholders. However, although a takeover can result in a big short-term profit, a forced takeover gives shareholders little alternative but to accept the terms of the takeover and tender their shares. If large shareholders support the deal, then even legal provisions that call for a shareholder vote won't give small investors any real say in the matter.

Even though a shareholder may get a quick profit, it may well be that the long-term profits of continuing to own the acquired company would have been much higher. Consider, for instance, how much different the investing world might have been had Microsoft (NASDAQ:MSFT) been acquired in 1990 for a split-adjusted $1.50 per share. In the short term, investors would have been pleased to get a big premium over the trading price of $0.90. In the long run, however, they would have missed out on the big gains that followed. Given a choice, many investors with long-term perspectives may prefer not to be bought out even at a premium, because they see greater prospects for big profits in the years and decades to come.

Knowing whether a company has a poison pill or other defense against takeovers can tell you a lot about how the company's management deals with issues that affect both shareholders and the managers themselves. Whether or not they are beneficial depends on the goals you have for investing in the particular company.

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Microsoft is a pick by The Motley Fool's newsletter Inside Value, which aims to find stocks that offer more to investors than their current share price suggests. You can take a look at what Fool expert Philip Durell and his team are recommending by signing up for a free 30-day trial.

Fool contributor Dan Caplinger avoids pills, poison or not, whenever possible. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy is an antidote to biased information.

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