Why is a shareholder rights plan called a "poison pill?"

To avoid being the target of a hostile takeover by a larger firm, a corporate board might adopt a defensive strategy called a shareholder rights plan. Such plans allow existing shareholders the right to purchase additional shares at a discount, effectively diluting the ownership interest of any new, hostile party. Most plans are triggered whenever one individual or entity obtains a certain percentage of total ownership, leading to the nickname "poison pill."

An example of a poison pill defense occurred in 2012, when Netflix announced a shareholder rights plan had been adopted by its board just days after investor Carl C. Icahn acquired a 10% stake. The new plan stipulated that with any new acquisition of 10% or more, any Netflix merger or Netflix sales or transfers of more than 50% of assets, existing shareholders can purchase two shares for the price of one.

Ever since their introduction in 1982, shareholder rights plans have had a very high rate of success in preventing hostile takeovers. There are obvious benefits for the existing board of directors, but shareholders benefit as well when the takeover might damage the stock's long-term value.

Another major benefit is that poison pills are extremely effective at discouraging monopolistic takeovers. Companies that might otherwise fall victims to overpowering large competitors can use the poison pill method to keep markets dynamic.

There are three major potential disadvantages to poison pills. The first is that stock values become diluted, so shareholders often have to purchase new shares just to keep even. The second is that institutional investors are discouraged from buying into corporations that have aggressive defenses. Lastly, ineffective managers can stay in place through poison pills; otherwise, outside venture capitalists might be able to buy the firm and improve its value with a better managing staff.