NEWS ALERT April 15, 2022, 1:39 p.m. EDT: In response to Tesla CEO Elon Musk’s $43 billion takeover offer, Twitter’s board of directors adopted a shareholder rights agreement, otherwise known as a poison pill, that would dilute Musk’s stake if he acquires more than 15% of the company’s common stock.
What Is a Takeover?
A corporate takeover is a complex business transaction pertaining to one company purchasing another company. Takeovers often take place for a number of logical reasons, including anticipated synergies between the acquiring company and the target company, potential for significant revenue enhancements, reduced operating costs, and beneficial tax considerations.
How Hostile Takeovers Work
In the U.S., most corporate takeovers are friendly in nature, meaning that the majority of key stakeholders support the acquisition. However, corporate takeovers can sometimes become hostile. A hostile takeover occurs when one business acquires control over a public company against the consent of existing management or its board of directors. Typically, the buying company purchases a controlling percentage of the voting shares of the target company and — along with the controlling shares — the power to dictate new corporate policy.
There are three ways to take over a public company: vertical acquisition, horizontal acquisition and conglomerated acquisition. The main reason for the hostile execution of acquisition, at least in theory, is to remove ineffective management or board and increase future profits.
Strategies to Avert a Hostile Takeover
With this in mind, some basic defense strategies can be used by the management of potential target companies to deter unwanted acquisition advances.
Poison Pill Defense
The first poison pill defense was used in 1982 when New York lawyer Martin Lipton unveiled a warrant dividend plan; these defenses are more commonly known as shareholder rights plans. This defense is controversial, and many countries have limited its application. To execute a poison pill, the targeted company dilutes its shares in a way that the hostile bidder cannot obtain a controlling share without incurring massive expenses.
A “flip-in” pill version allows the company to issue preferred shares that only existing shareholders may buy, diluting the hostile bidder’s potential purchase. “Flip-over” pills allow existing shareholders to buy the acquiring company’s shares at a significantly discounted price making the takeover transaction more unattractive and expensive.
Such a strategy was implemented back in 2012 when Carl Icahn announced that he had purchased nearly 10 percent of the shares of Netflix in an attempt to take over the company. The Netflix board responded by instituting a shareholder-rights plan to make any attempted takeover excessively costly. The terms of the plan stated that if anyone bought up 10 percent or more of the company, the board would allow its shareholders to buy newly issued shares in the company at a discount, diluting the stake of any would-be corporate raiders and making a takeover virtually impossible without approval from the takeover target.
Staggered Board Defense
A company might segregate its board of directors into different groups and only put a handful up for re-election at any one meeting. This staggers board changes over time, making it very time-consuming for the entire board to be voted out.
White Knight Defense
If a board feels like it cannot reasonably prevent a hostile takeover, it might seek a friendlier firm to swoop in and buy a controlling interest before the hostile bidder. This is the white knight defense. If desperate, the threatened board may sell off key assets and reduce operations, hoping to make the company less attractive to the bidder.
Typically, the white knight agrees to pay a premium above the acquirer’s offer to buy the target company’s stock, or the white knight agrees to restructure the target company after the acquisition is completed in a manner supported by the target company’s management.
Two classic examples of white knight engagements in the corporate takeover process include PNC Financial Services’ (PNC) purchase of National City Corporation in 2008 to help the company survive during the subprime mortgage lending crisis, and Fiat’s (FCAU) takeover of Chrysler in 2009 to save it from liquidation.
Greenmail Defense
Greenmail refers to a targeted repurchase, where a company buys a certain amount of its own stock from an individual investor, usually at a substantial premium. These premiums can be thought of as payments to a potential acquirer to eliminate an unfriendly takeover attempt.
One of the first applied occurrences of this concept was in July 1979, when Carl Icahn bought 9.9 percent of Saxon Industries stock for $7.21 per share. Subsequently, Saxon was forced to repurchase its own shares at $10.50 per share to unwind the corporate takeover activity.
While the anti-takeover process of greenmail is effective, some companies, like Lockheed Martin (LMT), have implemented anti-greenmail provisions in their corporate charters. Over the years, greenmail has diminished in usage due to the capital gains tax that is now imposed on the gains derived from such hostile takeover tactics.
Stocks With Differential Voting Rights
A preemptive line of defense against a hostile corporate takeover would be to establish stock securities that have differential voting rights (DVRs). Stocks with this type of provision provide fewer voting rights to shareholders. For example, holders of these types of securities may need to own 100 shares to be able to cast one vote.
Establish an Employee Stock Ownership Plan
Another preemptive line of defense against a hostile corporate takeover would be to establish an employee stock ownership plan (ESOP). An ESOP is a tax-qualified retirement plan that offers tax savings to both the corporation and its shareholders. By establishing an ESOP, employees of the corporation hold ownership in the company. In turn, this means that a greater percentage of the company will likely be owned by people that will vote in conjunction with the views of the target company’s management rather than with the interests of a potential acquirer.
How the Williams Act Affects Hostile Takeovers
Hostile attempts to take over a company typically take place when a potential acquirer makes a tender offer, or direct offer, to the stockholders of the target company. This process happens over the opposition of the target company’s management, and it usually leads to significant tension between the target company’s management and that of the acquirer.
In response to such practice, Congress passed the Williams Act to offer full and fair disclosure to shareholders of the potential target companies, and to establish a mechanism that gives additional time for the acquiring company to explain the acquisition’s purpose.
The Williams Act requires the acquiring company to disclose to the Securities and Exchange Commission the source of funds that will be used to accomplish the acquisition, the purpose for which the offer is being made, the plans the acquirer would have if it is successful in the acquisition, and any contracts or understandings concerning the target corporation. While the Williams Act was designed to make the corporate takeover process more orderly, the increased use of derivative securities has made the Act a less useful defense mechanism. As a result, various types of corporate defense strategies need to be considered by the management of companies likely to be targeted for acquisition.
The Bottom Line
Corporations have many hostile takeover defense mechanisms at their disposal. Given the level of hostile corporate takeovers that have taken place in the U.S. over the years, it may be prudent for management to put in place preemptive corporate takeover mechanisms, even if their company is not currently being considered for acquisition. Such policies should be seriously pursued by companies that have a well-capitalized balance sheet, a conservative income statement that exhibits high profitability, an attractive cash flow statement and a large or growing market share for its products or services.
In addition, if the company exhibits significant barriers to entry, a lack of competitive rivalry in the industry, a minimal threat of substitute products or services, minimal bargaining power of the buyers and minimal bargaining power of the suppliers, the case for implementing preemptive hostile strategies while developing a thorough understanding of responsive takeover defense mechanisms is highly advised.