What Is a Poison Pill, Anyway?

SMITH BRAIN TRUST – It’s not often that a company’s board of directors employs a poison pill to fend off a hostile takeover. Even rarer is when a board of directors employs the tactic to hold a founder and former CEO at bay.

That’s what makes the current drama at Papa John’s so interesting.

The Louisville-based pizza company is shoring up its defenses amid an increasingly acrimonious situation with the chain’s founder and former chairman John Schnatter. It’s deploying the so-called poison pill strategy, aimed at blocking any shareholder from amassing a controlling interest in the company. Schnatter resigned as chairman this month after reports that he had used a racial slur.

David Kass, clinical professor of finance at the University of Maryland’s Robert H. Smith School of Business, explains the poison pill strategy (and why he’s not a fan).

The strategy, which in more formal circles is known as a shareholder rights plan, is a defensive tactic used to blunt a hostile takeover effort by activist investors or ambitious rivals. Perhaps the only recent example of the tactic being used against a company’s founder was American Apparel and its highly controversial founder, Dov Charney.

The strategy sets a maximum percentage of the company’s shares that can be acquired by any one shareholder. If a shareholder’s holdings top that threshold, it triggers a “poison pill,” essentially allowing all other shareholders – excluding the large potential acquirer – the opportunity to buy additional shares at a discount. Those buys, in effect, dilute the shares being held by the acquirer and, if successful, “chase the acquirer away,” Kass says. And it prevents, in essence, any takeover that doesn’t have board approval.

“The hope is that the cost rises substantially and becomes prohibitive for the acquirer to proceed.”

Often, Kass says, a company’s senior executives and corporate board will adopt the defensive poison-pill approach “because for whatever reason, they don’t want the company to be acquired.”

It’s usually a matter of self-interest, he says, not shareholder interest. And that’s where Kass’ disfavor comes from.

“The board and the senior management are supposed to be acting in the best interests of their shareholders, in theory,” he says. “But in practice there is often a conflict of interest between them, on the one hand, and shareholders, on the other. The poison pill is introduced, in many cases, because senior management wants to keep their jobs.”

This is typically not so favorable for shareholders. A successfully administered poison pill strips away the potential opportunity to be paid the premium share price that typically accompanies a takeover effort, says Kass. The average premium above the share price paid in a corporate takeover is about 25 percent. 

“It could be 25 percent – or more,” Kass says, noting the possibility of a bidding war among multiple buyers.

A poison pill also typically weighs on a stock, because it discourages any other potential bidders from stepping forward with a merger or acquisition deal. In Papa John’s case, the common stock fell about 9 percent on news of the poison pill.

“This is a case of the board and management acting in their own self-interest at the expense of their outside shareholders,” Kass says.

Corporate board members and senior leadership may argue that the poison pill was administered to protect long-term shareholder interests.  But Kass says that in many cases, including Papa John’s, he doesn’t really buy that.

“It’s a smokescreen,” he says. “Senior management and the board of directors, it appears, are just looking out for their own self-interests.”

Kass says the poison pill is an abuse of shareholder rights, similar to the so-called “scorched earth” tactic, in which a company targeted by a hostile takeover attempt will sell off its most profitable arm in hopes the would-be acquirer might lose interest.

“Once again that hurts the shareholder. These are tools used by senior management and boards of directors that want to remain entrenched,” says Kass, who wrote a paper on the topic decades ago. “What I found back then, and it’s probably true today.” 

In his research, Kass examined the market value of the CEO’s stock in the company as a ratio to the CEO’s annual compensation. He found that lower the ratio – that is, the lower the stake in the company stock that the CEO had relative to cash compensation – the harder the CEO would fight potential takeover attempts. In other words, he says, self-interest over shareholder interest.

In the case of Papa John’s, Schnatter owns about 30 percent of company’s stock and that leaves the remaining senior management and the board in a vulnerable spot, Kass says. “They want to protect their own situation. They just kicked him out. It stands to reason that if he were to regain control of the company, he might kick them out.”

It appears that Papa John's has a major problem with corporate governance, Kass says.

Bottom line? Says Kass, “Let the shareholders vote.” 

“It’s a democracy. So, ask the shareholders what they would prefer: Let the stock fall 9 percent and go nowhere? Or go back up at 9 percent, plus receive a premium? Take the money and run. That’s a shareholder decision.”