Defense Mechanism

Behavior that people use to separate themselves from unpleasant events, actions, or thoughts

Author: Abhinav Bhardwaj
Abhinav Bhardwaj
Abhinav Bhardwaj
As a highly motivated final year student and Summer Analyst at Park House Partners, I possess a strong track record in finance through academics, bolstered by my previous roles as a Finance Research Analyst and Treasurer for Aber Asian Society. With a deep passion for the field, I excel in investment analysis and financial modelling. Currently, I am actively engaged in conducting comprehensive market research, evaluating investment opportunities, and presenting insightful reports. Proficient in analysing financial statements, identifying emerging market trends, and delivering compelling presentations. As a former Treasurer for Aber Asian Society, I successfully managed financial activities while fostering inclusivity through dynamic cultural events. Committed to further enhancing my expertise in finance to drive impactful contributions in the industry.
Reviewed By: Tamanna Hassan
Tamanna  Hassan
Tamanna Hassan
Passionate learner and educator.
Last Updated:March 13, 2024

What Is a Defense Mechanism?

Defense mechanisms are behaviors that people use to separate themselves from unpleasant events, actions, or thoughts. Similarly, in an M&A, the target firm takes a few measures to resist the takeover. 

Mergers and acquisitions (M&A) are frequently used to broaden a company's reach, enter new markets, or increase market share. All of this is done to boost the value of the company's stock.

Mergers and acquisitions is a general term that defines the consolidation of firms or assets through several forms of financial transactions, including mergers, acquisitions, consolidations, tender offers, acquisitions of property, and management acquisitions.

Any collection of practices used by a target business in an M&A transaction to thwart a hostile takeover is a defensive mechanism (also known as a defense strategy). 

A hostile takeover is a form of acquisition in which the bidder acquires the target business against the wishes of the target's management and board of directors. A bidder purchases a controlling position in the target company to carry out hostile takeovers.

The question of fiduciary responsibility occasionally makes the use of defense mechanisms contentious. 

For instance, if the management of a target firm opposes a takeover, they might take advantage of the information gap between them and the company's shareholders to thwart the acquisition even though it might benefit them.

Defensive tactics often fall into pre-offer defense tactics or post-offer defense tactics.

When management rejects a takeover offer, it has the following options to protect the business:

  • Attack the rationale behind the offer and the management caliber of the bidder.
  • Boost the company's reputation. Consult public relations experts.
  • Request a regulatory investigation. Encourage stakeholders, legislators, and unions to advocate on your behalf.

Key Takeaways

  • Defense mechanisms in mergers and acquisitions are strategies employed by target companies to resist hostile takeovers.
  • Defense mechanisms can be categorized into pre-offer and post-offer tactics. Pre-offer defenses aim to deter potential bidders, while post-offer defenses come into play after a takeover bid has been made.
  • Defense mechanisms are implemented to ensure that the target company's management and board can act in the best interests of shareholders. However, their use can be contentious, as they may be perceived as protecting management's interests over those of shareholders.

Types of Pre-Offer Defense Mechanisms

A preventive tactic is a pre-offer defense. It is primarily used to either impose constraints on corporate governance to restrict the benefits to the possible bidder or reduce the attractiveness of the company's shares to a potential bidder (e.g., raise the total purchase costs). 

The following tactics are part of the pre-offer defense mechanisms:

1. Poison pill

To make it more complex and more expensive for a potential acquirer to acquire a controlling interest in the target, the poison pill defense comprises diluting the target company's share price. 

The flip-in poison pill is the issuing of extra shares of the target firm, which current owners can purchase at a large discount.

Shareholders of the target firm have the chance to purchase shares in the acquiring company at a steep discount thanks to the flip-over poison pill.

2. Poison put

The poison put defense is similar to the poison pill defense in that it seeks to raise the overall acquisition cost. The target company issues bonds that can be redeemed before their maturity date in the case of a hostile business acquisition. 

This is known as the "poison put approach." The potential acquirer must consider the additional cost of repurchasing bonds when that commitment becomes a current obligation after the takeover.

The "poison out" method, in contrast to the poison pill, has no impact on the volume of shares outstanding or their price. However, it can cause the acquirer serious cash flow issues.

3. Golden parachutes

Golden parachutes are benefits, bonuses, or severance payments that top management employees of a firm may be entitled to if they are fired (as would happen in the case of a hostile takeover). 

To raise the total acquisition cost for a bidder, they can be used as yet another takeover defensive strategy.

4. Supermajority Provisions

A supermajority clause is a change to the corporate charter that stipulates that the board can only authorize a merger or acquisition of the firm if a significant majority of its shareholders (usually between 70% and 90%) vote in favor of it. 

The customary simple majority provision, which simply needs approval from more than 50% of the voting shares, is superseded by the supermajority clause.

5. Just say NO, defense.

A "just say no" defense is used by boards of directors to deter hostile takeovers by flatly rejecting any offer the potential buyer could make and refusing to engage in further negotiations.

If the target company has a long-term strategy it is pursuing, which may involve a merger with a company other than the one making the takeover proposal, or if the takeover bid undervalues the company, the legality of a "just say no" argument may depend on these factors.

6. Recapitalization

A corporation may choose to restructure its financial system or increase its financial stability by recapitalizing. To do this, the corporation must alter its debt-to-equity ratio by increasing its debt or equity capital.

Recapitalization frequently changes a corporation's proportion of debt and equity to stabilize the capital structure

The procedure generally entails substituting one kind of funding for another, such as doing away with preferred shares and covering bonds in the company's capital structure.

7. Staggered board

A board with classes of directors that have terms of varying durations is known as a staggered board. A staggered board is often constituted to deter a prospective hostile takeover offer. 

An average staggered board contains three to five classes of posts, each with a range of terms of office that allow for staggered elections.

A staggered board might act as a company's defense against an influential investor trying to make a quick profit or a hostile bidder who might want to split the business up right away after gaining control.

8. Standstill agreement defense

A standstill agreement is a contract that specifies how a firm's bidder may purchase or dispose of shares of the target company. If the parties cannot come to an amicable agreement, it can effectively postpone or stop the hostile takeover process. 

The "status quo" on a certain issue may be maintained by the parties to the agreement. The agreement is significant because it means the bidder would access sensitive financial data about the target company. 

After obtaining the pledge from the potential acquirer, the target company gains extra time to put other acquisition defenses in place. In some circumstances, the target company agrees to purchase its equity shares back from the potential acquirer at a premium.

9. White squire defense

An investor or ally firm was known as a "white squire" purchases stock in a target company to thwart a hostile takeover. 

Like a white knight defense, this one does not require the target corporation to give up its independence since the white squire acquires a portion of the company.

Unlike a white knight, who needs a controlling interest, a white squire is a friendly acquirer. To prevent a hostile takeover, a white knight purchases the entire business. A white squire purchases a piece of the company.

Their stake is substantial enough to dissuade the bidder and allow the target company time to reconsider its approach.

Types of Post-Offer Defense Mechanisms

When a target firm receives a bid for a hostile takeover, post-offer defense strategies are used.

The following are some instances of post-offer defense mechanisms:

1. Greenmail defense

The "greenmail defense" refers to the target firm repurchasing its stock from a hostile takeover bidder who has already amassed a sizable shareholding. 

The target business must pay a significant premium over the current market price to repurchase the shares, making it an expensive defense.

Instead of continuing with the takeover, the potential acquirer takes the greenmail profit it receives from reselling the target company's shares to the target at a premium.

Although this tactic is lawful, the acquirer effectively uses the target firm as blackmail by demanding a premium in exchange for ceasing the takeover attempt through share buybacks.

2. Crown jewel defense

The most valuable assets of a target corporation are either sold to a third party or spun off into a different entity as part of the crown jewel defense strategy. The fundamental objective of the crown gem protection plan is to make the target organization less alluring to corporate robbers.

The target corporation disposes of priceless assets in a crown jewel defense to lessen its allure. To avoid a hostile takeover, the target business must essentially destroy value and harm itself in a crown jewel defense.

3. White knight defense

When a firm is about to be acquired by an "unfriendly" bidder or acquirer, a "friendly" person or business will buy it reasonably. This is known as a "white knight" hostile takeover defense. The "black knight" is used to describe the hostile bidder.

Even though the target company loses its independence, a white knight acquisition is still preferable to a hostile takeover. In contrast to a hostile takeover, a white knight scenario often results in present management staying in place and investors receiving higher remuneration for their shares.

4. Pac-Man defense 

When a target firm tries to buy its prospective acquirer after receiving a takeover bid, it uses the Pac-Man defense.

The target begins purchasing shares of the acquirer to gain a controlling stake in the acquirer at the same time that the acquirer is attempting to acquire a majority of the shares in the target business.

Of course, such a plan can only succeed if the target firm has the money to buy the necessary shares in the acquirer. When the acquirer perceives a threat to its ability to run its own company, they frequently give up trying to purchase the target.

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