When two companies combine on Wall Street, it’s usually by mutual agreement. The buyer wants to buy and the seller wants to sell.

But sometimes, the interest is one sided. The buyer wants to buy, but the target company doesn’t want to sell.

If the target company’s board of directors doesn’t approve a sale, the acquiring company can try a hostile takeover. Since a corporation’s owners are its shareholders, if the potential buyer gets enough shareholders to back a takeover, the deal can still be done.

Tender Offer

One way the potential buyer tries to bypass the board is to make a tender offer to shareholders of the target company to buy their shares. The offer is typically made at a premium to the stock’s market price to give shareholders more incentive to say okay.

If the buyer is able to obtain enough shares for controlling interest (the majority of voting shares) in the target company, it can vote for the merge. Usually the tender offer is conditional on the buyer getting enough shares for controlling interest. If this doesn’t occur, the offer is withdrawn.

However, a tender offer made at a premium helps the target company’s stock rally, benefiting shareholders.

Proxy Fight

The potential buyer could also try to get control of the board through a proxy fight. It will nominate candidates who will support a takeover to replace members of the board that blocked a merger. Before a shareholder meeting, it will mail proxy ballots to shareholders to make a case why they should vote for certain candidates.

If they want to vote in favor, the shareholders can instruct the designated proxy to cast votes on their behalf at the meeting. If enough shareholders vote for the board change, the new board can vote in favor of a merger.

Note that the target company will also send a proxy ballot to try to convince shareholders to support its candidates. To entice the shareholder to vote against a merger, a company can propose changes that hopefully will improve financial results and create value for shareholders. Or it could opt for one-time “treats” to sweeten the deal, such as special dividends and share buybacks. These moves are favorable to shareholders and can boost the stock price.

A Wake Up Call

Usually a target company is vulnerable to a hostile takeover because current management is not doing a good job. Otherwise, if shareholders have faith in the current management and don’t believe a change is good, they will not back a merger.

Thus, even if the hostile takeover attempt does not succeed, it could still serve as a wake-up call to current management. It can get them to self-analyze and hopefully make changes that benefit shareholders.

For example, they may decide to reduce executive compensation or at least make the pay more incentive-based, or they could decide to divest under-performing assets to leave a stronger core. The changes could result in better company financial results and a higher stock price both in the short and long term.

Tough Pill to Swallow

Sometimes, a takeover target will deploy a tactic commonly known as a “poison pill” (officially known as a “shareholder rights plan”) to defend against a possible hostile takeover. The shareholder rights plan stipulates that if certain conditions are met, existing shareholders will have the right to purchase additional shares at a large discount. Once triggered, this leads to tremendous share dilution and make it much more difficult for the potential acquirer to obtain controlling interest.

For example, a well-known poison pill example occurred in 2012 when Netflix (NSDQ: NFLX) defended itself against activist investor Carl Icahn.

After Icahn bought a 10% stake in Netflix, the company gave its shareholders the right to buy two shares of NFLX for the price of one if anyone else bought a new stake of 10% or more or if Netflix is involved in any merger. During the steep market decline earlier this year, dozens of companies fearful of being taken over also adopted poison pills.

A poison pill could also be used as a negotiation tactic to force the interested buyer to make a more compelling offer. Studies have shown that takeover targets with a poison pill in place resulted in a higher premium and thus a better stock price for shareholders. Despite the toxic-sounding name, a poison pill could be manna for shareholders.

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Editor’s Note: Our colleague Scott Chan just explained how merger and acquisition activity can enrich investors. But maybe this topic doesn’t fit your investing style.

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