A poison pill is a defensive measure used by listed companies to guard against hostile takeover attempts. The tactic is designed to protect a company against potential acquirers and activist investors who attempt to gain major stakes in the company without the board’s consent and without offering a premium to all shareholders. Poison pills aim to make a takeover more difficult and expensive so that it is not necessarily in the best interest of the potential acquirer.

When a poison pill is activated, it establishes a maximum stake any investor can acquire in the company, and it also has the effect of diluting the holdings of any shareholders who exceed the maximum stake. These shareholders will receive additional discounted or free shares in order to reduce their overall holdings.

The effectiveness of a poison pill defense tactic, however, is dependent on the company being able to prove  proportionality. That is, the company must show that the poison pill response is proportional to what they perceive as a credible threat. If they cannot demonstrate this, then investors may be able to persuade other shareholders to vote off the current board and replace them with members more favorable to their positions.

The use of poison pills is a controversial issue and is not without its detractors who point to the entrenchment of current company managers and boards as an issue. Other detractors worry about the dilution that the poison pill will cause for the company’s common stock, and the potential negative impacts on shareholder value.

Yet despite these concerns, poison pills remain a popular method of defense against hostile takeovers, and many listed companies still employ them in their defense strategies. The key for companies using the tactic is to be able to show that their response is proportional to the perceived threat and not just a preemptive measure to keep a hostile or activist investor out.