What is a Defense Mechanism?
In M&A transactions, a defense mechanism (also known as a defense strategy) is referred to as a set of procedures that are employed by a target company to prevent a hostile takeover. A hostile takeover is a type of acquisition in which a bidder takes over a target company without the consent of the management or board of directors of the target. Hostile takeovers are executed through the acquisition of a controlling interest in a target company by a bidder.
In some cases, the agency problem can make defense mechanisms a controversial issue. For example, if the management of a target company resists a takeover for some reason, they may exploit the information asymmetry between them and the company’s shareholders and prevent the takeover using defense strategies even if the deal can potentially create value to the shareholders.
Generally, defense mechanisms can be divided into two broad categories: pre-offer defense mechanisms and post-offer defense mechanisms.
Types of Pre-Offer Defense Mechanisms
The pre-offer defense is a preemptive strategy. It is primarily used to either make the company’s shares less attractive for a potential bidder (e.g., increase the overall acquisition costs) or set the restrictions in corporate governance to limit the benefits to the potential bidder. The pre-offer defense mechanisms include the following strategies:
1. Poison pill
The poison pill defense includes the dilution of shares of a target company in order to make obtaining the controlling interest by a bidder more complicated. The strategy may come in two different forms. The flip-in poison pill is the issuance of preferred shares only to the existing shareholders of the target company. On the other hand, the flip-over poison pill provides an opportunity for the target company shareholders to purchase the shares at a significantly discounted price.
2. Poison put
The poison put defense can be considered as a variation of a poison pill as the defense mechanism also intends to increase the total cost of acquisition. Essentially, the poison put strategy involves the issuance of bonds by a target company that can be redeemed before the maturity date. The repurchase provision of the bonds can be executed only the acquisition of the target company.
Unlike the poison pill, the poison out strategy does not affect a number of shares or their price. However, it increases the acquisition cost for the potential bidder. If the bonds are redeemed at the time of acquisition, the bidder is required to offer cash to acquire a controlling interest in the target company, as well as to repay the bondholders.
3. Golden parachutes
Golden parachutes are referred to as the benefits and/or bonuses to the company’s top manager in case of termination of their employment. They can be employed as a defense mechanism as they also increase the total acquisition cost for a bidder.
4. Supermajority provisions
A supermajority provision is an amendment in the corporate charter stating that a merger or an acquisition of a company can be approved by the board of directors only if a significantly large number of shareholders (typically between 70% to 90%) approves the transaction. The supermajority provision supersedes the simple majority provision, which requires votes from more than 50% of shareholders.
Types of Post-Offer Defense Mechanisms
On the other hand, post-offer defense mechanisms are employed when a target company receives a bid for a hostile takeover. The examples of post-offer defense mechanisms are:
Greenmail takes place when the target company buys back its shares from a corporate raider who has already acquired a substantial number of shares for a hostile takeover. The practice can be successful only if a target company purchases back its shares at a substantial premium.
2. Crown jewel defense
The crown jewel defense strategy involves selling the most valuable assets of a target company to a third party or spinning off the assets into a separate entity. The main goal of the crown jewel defense strategy is to make the target company less attractive to the corporate raider.
3. Pac-Man defense
The Pac-Man defense occurs when a target company attempts to acquire its potential buyer when a takeover bid has already been received.
4. White knight defense
The white knight defense is a strategy that involves the acquisition of a target company by its strategic partner called a white knight instead of a corporate raider. It is generally considered the last protection from a hostile takeover when no other strategies can be employed.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: