Booyah Breakdown: Poison Pill Primer

Some people find them easy to swallow, some not; here's why.
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Back in the days of James Bond and his pussycats, spies carried poison pills.

That way, if their identities were ever revealed, they'd take the poison pill -- usuallycyanide pellets -- and sacrifice their lives to eliminate the possibility that they could beinterrogated for the enemy's gain.

Almost sounds romantic.

The poison pill is still around today, although under a much less theatrical guise. Thesedays "a poison pill," created during the early 1980s to ward off corporate raids by businessmenlike Carl Icahn, is a shareholders' attempt to eliminate a hostile takeover of their company.

And acquisitions are in the air these days. For instance, the

Chicago MercantileExchange

(CME) - Get Report

said it would buythe Chicago Board of Trade for $8 billion,

Level 3 Communications

(LVLT)

is going to acquire Broadwing and

Eli Lilly

(LLY) - Get Report

is buying Cialis maker Icos.

And don't forget

Google's

(GOOG) - Get Report

recent $1.65 billion stock purchase of YouTube.

All these acquisitions are seemingly friendly -- the little guy actually wants the big guy tobuy him.

But what if some company wants to come in and scoop up a little company against theshareholders' wishes. Are the shareholders at the mercy of the big fat institution?

Not if they have a poison pill in place. And no, that doesn't mean they're giving cyanideout to the acquiring company's board of directors. (Although there are clearly momentswhen ... )

Instead, companies have found that the corporate poison pill defense can be an extremelypotent weapon for warding off hostile takeovers.

That's probably why Rupert Murdoch was so tickled last week that

News Corp's

(NWS) - Get Report

shareholders approved apoison pill defense that would help prevent rival John Malone's

Liberty Media

(LCAPA)

from buying abig chunk of Rupert's shares.

If the poison pill had been vetoed, it would've opened the door for Malone to take control of NewsCorp, which would infuriate Murdoch, who plans to leave control of the company to his offspring.

But that's when your questions started coming in. We've all heard the term "poison pill," andCramer often talks about how you can profit from corporate transactions. But many readers wantedfurther explanation.

So here it is -- the poison pill. And I promise, it has nothing to do with lethal substances.

Go Ahead, Take Your Medicine

A poison pill is an agreement issued by the company to the shareholders (the typical pilldoesn't require shareholder approval, a la News Corp.) And that agreement gives the shareholdersthe right to buy a ton of newly-issued shares at essentially half the price.

If the pill is activated and shareholders take advantage of it, they'll flood the market withnew shares and thereby dilute the stock. Then the market price of those new shares will increase -- which is precisely why a company will activate its poison pill agreements to prohibit an unwantedtakeover.

Example time. Here's a very simple explanation of how the stock gets diluted when the pill isactivated.

Let's say there are 100 shares out there of a sweet little company at $20 a piece; total valueof the company is $2,000. Now our big mean potential suitor comes in and wants to buy 20% of thecompany. To gain that control, he'd have to buy 20 shares, costing $400.

But let's presume we don't want him to buy our shares; the poison pill is activated and shareholders can now buy another 100 shares at, say, $10 each.

Great. But now there are 200 shares in the market. If the mean suitor wants to own 20%, henow has to buy 40 shares, which will cost him a market price of closer to $800. (The overall market price will come down a bit with the influx of new shares, but you get the idea.)

So that pill just doubled the meanie's cost.

Using this strategy may sound manipulative, but these poison pills have been deemed legal in court,mainly because if the big mean company really wants to buy the nice company, it still can. No one isstopping them ... they'll just need to ante up more money.

But while the big mean guy decides if he wants to cough up more cash, the little guy justbought himself more time to either get a better price or find a more amicable buyer, says JoeUnger, chairman of the mergers & acquisitions committee for the New York State Society of CPAs. "So the pillgives him breathing space."

And that's exactly what it did for PeopleSoft back in 2003, when

Oracle

(ORCL) - Get Report

was on its tail to scoop it up.

Oracle's original offer to take over PeopleSoft in June 2003 was $16 a share, or $5.1 billion.But PeopleSoft's shareholders took advantage of their poison pill. Oracle then raised its offerseveral times (and even lowered it once) during the course of this hostile bid. But PeopleSoft'sboard continued to resist CEO Larry Ellison and his vultures.

In the end, Oracle bought PeopleSoft for $10.3 billion in cash, or $26.50 a share, a bigincrease from Oracle's original offer. Seems the pill worked.

The Cool Kids Don't Take Pills

While the pill seems dreamy, there are many shareholders who believe in them. Mainly becauseonce the pill is activated, the board is put in control of either finding a better buyer ornegotiating a better price.

But a company's institutional investors usually don't want the board in control. Those biginvestors believe they can take care of themselves, notes William Regner, corporate partner andmember of legal firm Debevoise & Plimpton's M&A group. The last thing they want is to place more control withthe so-called apathetic board of directors. Institutional shareholders are powerful enough to makeor break takeover decisions on their own.

That's because without the pill, shareholders -- big and small -- can decide for themselves ifthey want to be taken over, and the larger shareholders believe it ought to remain their choice --not the board's. "They want to be able to vote themselves," says Regner.

Finally, remember that even if your company doesn't have a poison pill agreement in place, it could whip one upin a jiffy. In the end, though, very few pills actually get used.

Still, it's always good to have protection.

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;

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