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A hostile takeover occurs when a company or individual attempts to gain control over a target company by sidestepping their management and board of directors. That’s what makes the takeover hostile — merging with or acquiring a company against the wishes of that company’s management.

Hostile takeovers can be a major distraction for companies and some employ a range of defensive tactics to protect their management’s decision-making power and thwart a hostile takeover. Here’s what else you should know about hostile takeovers and how they work.

How a hostile takeover works

Hostile takeovers often begin as friendly offers. The acquiring company may make an offer to the target company as it quietly works in the background to convince board members and management to take the deal. Things  turn hostile once the target company’s board refuses the deal, and the acquirer goes directly to the shareholders.

The acquirer can force the deal in one of three primary ways:

  • Tender offers: Tender offers are usually an offer to purchase shares at a premium to their market price and only lasts for a specific time. For the hostile takeover to be successful, the acquirer would need a majority of the shares to accept the tender offer.
  • Proxy fights: A proxy fight replaces current board members who oppose the takeover with representatives of the potential acquirer. The acquirer would make its pitch to shareholders in the hope that they vote their proxy in favor of its slate of director nominees.
  • Stock purchases: A company or group of investors may also purchase shares in the open market as a way to gain influence or control over a company. However, once a certain ownership threshold is reached, the purchases must be disclosed, which could trigger a hostile takeover defense from the target company’s management.

Hostile takeovers are more often directed at established companies with a record of underperformance. If management hasn’t taken concrete actions to correct the underperformance, outside investors or other firms may look to get involved with a hostile offer. Because of the underperformance, existing shareholders may be more amenable to accept a hostile takeover, or at least implement change at the management or board level.

Hostile takeovers can cause a lot of disruption for the target company and its employees. It can lead to massive layoffs, as the acquirer looks to cut costs and boost profitability. New owners may also look to cut underperforming business units or shift  capital allocation priorities in an attempt to make the company more  cost-effective or profitable.

Hostile takeover vs. friendly acquisition

A takeover may be friendly if the target company supports a proposed deal, but things can get ugly if a deal turns hostile.

In a friendly acquisition, the acquirer and target company have often been in discussions or negotiations for weeks or months prior to announcing a deal. The target may agree to share certain information with the bidder to better inform the possible deal. Once a deal is reached, the two companies announce the acquisition together and often have a call with shareholders and analysts touting the benefits of the deal.

In contrast, hostile takeovers often come about after a target company’s management has either rebuffed or refused to engage with the potential acquirer. The acquirer appeals directly to the target’s shareholders, typically offering a premium price for the stock and a plan to boost the company’s future prospects. Management may try to smear the reputation of the acquirer or paint a group of investors as corporate raiders in an attempt to get shareholders to reject any offers.

Hostile takeover defenses

If the directors and management of a target company want to defend against a hostile takeover bid, here are some of the most typical strategies:

  • White knight: The white knight defense involves the target company finding a friendlier buyer than the potential acquirer. The white knight may be a company that agrees to acquire the target entirely, or it could be a large investor.
  • Greenmail: Greenmail occurs when a company agrees to buy shares at an inflated price from one of its investors. The company is willing to pay extra in order to rid itself of the investor. Some companies have adopted provisions that prevent them from paying greenmail because the move is viewed as protecting management at the expense of shareholders.
  • Stockholder rights plan: Also known as a “poison pill,” this strategy is used by target companies to make their shares unattractive to the potential bidder. They may allow existing shareholders to purchase shares at a discount in an effort to dilute its shares and limit the acquirer’s ability to gain control.
  • Staggered board: Companies may divide the service terms of their board members into different tiers so that only a few are up for election in any given year. This makes it harder  for a hostile bidder to win control of the board through a proxy fight in any single year.
  • Differential voting rights: Some companies have different classes of shares (dual share classes, for example) that come with different voting rights, which may limit the ability of an acquirer to accumulate voting power. A few key insiders, such as the company’s founders, may receive shares with 10 times the votes of the normal shares, for example.
  • Defensive merger: When a company is concerned about a hostile takeover, it may try to acquire another company and could take on a lot of debt to do so. This move is about making itself less attractive to the potential acquirer but is typically bad for shareholders. The company may end up saddled with too much debt and an asset that it doesn’t want or overpaid for.

Are hostile takeovers good for investors?

Hostile takeovers can be both good and bad for investors. Investors may receive a premium for their shares through a tender offer or if an acquisition takes place. The mere threat of a hostile takeover can also shake up management and force them to implement shareholder-friendly changes, such as a boost to dividends or share repurchases.

But hostile takeovers are also a huge distraction for  management. They take up a lot of the leadership’s time and may cause them to lose focus of their core business operations. They could also adopt defenses that destroy value for shareholders, such as overpriced acquisitions or greenmail.

Bottom line

For investors, a hostile takeover can create both opportunities and risks. It can be a good time to buy the stock of the target company in order to benefit from the premium the acquirer is offering to shareholders. On the other hand, investors should proceed with caution, since an acquisition of this kind can destroy value for shareholders if the acquirer is overly focused on short-term profits or management dilutes the shares to thwart the takeover.