A lobster trap is a strategy that target companies utilize in the event of a hostile takeover attempt. The strategy involves the use of a charter issued by the target company with a directive that prevents shareholders with more than 10% of convertible securities – which includes warrants, convertible bonds, and convertible preferred stock – from transferring or converting their shares into voting stocks.
The term is taken from the basic concept of lobster traps used to catch lobsters. The traps are designed to catch the largest of the lobsters – which are useful (or, in the case of a takeover, are dangerous and must be caught) – and allow the smaller ones to get away.
How a Lobster Trap Works
Lobster traps are designed to help a target company avoid being taken over, usually when a hostile takeover attempt is occurring.
One option for acquiring companies to use when attempting a hostile takeover is to purchase a substantial number of shares of the target company. This can be accomplished through a number of tactics, including:
1. Dawn raid
A dawn raid takes place when shareholders of the acquiring company sweep in as soon as the market opens and purchase a large number of shares in the target company.
2. Godfather offer
A Godfather offer refers to a tender offer made to the shareholders of the target company that is so ridiculously favorable that few shareholders would refuse to tender their shares to the acquiring company. The more shareholders that agree, the more shares the acquiring company can get.
In the event that an acquiring company uses either of the above methods for a hostile takeover, if the target company contains a lobster trap in their corporate charter, it can stop some of the voting shares and securities from being turned over to the acquiring company.
Example of a Lobster Trap
Lobster traps are particularly useful when a larger company is looking to take over a smaller company.
Let’s assume that Company A is a small business that’s been targeted by Company B for a hostile takeover. Company A is aware that there is a major fund that owns 12% of its voting shares and other convertible securities that would ultimately give the fund another 2%-3% share in Company A.
The good news for Company A is that they planned ahead for such an event and instituted a lobster trap in their charter. This means that the fund cannot convert its convertible securities into stock shares with voting rights. The move makes it less likely that another company can take a controlling position in the target. If the lobster trap was not in place, Company B could purchase a controlling number of shares in Company A, remove members of the board of directors, and put in place members that would accept the takeover bid.
Lobster traps are vital tools for companies trying to avoid a takeover that they aren’t willing to agree to. The lobster trap makes it easier – especially for smaller companies – to prevent a company from enacting a hostile takeover by buying up a controlling number of shares and making changes that would allow them to take over.