In finance, a scorched earth policy is a tactic that a company can use to prevent a hostile takeover. Essentially what happens is that a company targeted for takeover does everything it can reasonably do to make itself unattractive, hopefully discouraging the potential acquirer from continuing the takeover attempt.
Scorched Earth Policy Tactics
In order to make itself less attractive, a targeted company may do a number of things, including:
Liquidating or terminating significantly valuable assets and securities
Making agreements to repay debts as soon as the hostile takeover is completed. The acquiring company would then be forced to pay off the outstanding debt, thereby eroding its profits.
Trying to “scorch” the acquirer as well by using a “poison pill” tactic such as the flip-over strategy, which enables shareholders of the target company to purchase discounted shares of the acquiring company if the takeover is successful. This move will dilute the value of the acquiring company’s outstanding shares.
Origin of the Scorched Earth Policy
The term “scorched earth” started as a military term. During times of war, troops would destroy valuable goods – crops, buildings, routes in and out of towns – in order to make them unusable by enemy troops.
The downside to the scorched tactic is that the items and infrastructure that were destroyed could also no longer be used by the troops who destroyed them.
Issues with the Scorched Earth Policy
When a company deliberately takes action to make itself less attractive, the goal is to prevent a takeover attempt. In the event that the policy works, the targeted company achieves its desired result, escaping the takeover. There are two major problems that may arise from implementing the scorched earth policy:
The acquirer may still see underlying value in the targeted company and follow through with the takeover anyway, assuming it can restore the target company to its former value once it’s in a position of ownership.
The scorched earth tactics may result in the target company severely damaging itself and reducing its earning potential. Many companies targeted for a hostile takeover that implement the scorched earth tactic may successfully prevent the takeover attempt but find they aren’t able to recover from their self-inflicted damage. Some may eventually be forced into bankruptcy and liquidation. Consider, for example, a software company that, as part of its scorched earth takeover defense, sold all the rights to market some of its key proprietary software to a competitor.
The scorched earth policy is, at its core, a final, desperate effort by a company to stop a hostile takeover. Other anti-takeover strategies are often better options because they don’t sabotage the value and earning potential of the targeted company.
For some companies, the scorched earth policy is successful and the company recovers after the takeover bid fails. For the rest, however, either the takeover is not prevented or the self-sabotage effectively ruins the company.