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Lobster Trap

Updated on May 23, 2024
Article byWallstreetmojo Team
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

Lobster Trap Meaning

Lobster Trap refers to the strategy the company uses under the target to prevent itself from a hostile takeover. The shareholders having the ownership of converting stock of more than 10% in the company cannot convert their securities into voting stock. However, this strategy cannot be used as a standalone measure; it has to be in combination with other strategies to be strong enough to weather the risks of a takeover.

Lobster Trap

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The lobster trap defense emerges as a formidable tactic against hostile takeovers. This defensive maneuver involves creating intricate financial structures that make it challenging for potential acquirers to extricate themselves once they initiate the takeover process. While it can act as a robust deterrent, its limitations are the potential strain on shareholder value and the delicate balance required to protect the company without hindering its growth prospects.

Lobster Trap Explained

Lobster Trap is a tactic used by the targeted company to prevent any hostile takeover. In these tactics, the owners of more than 10% of converting securities of the company won’t convert the securities into voting stock. The tactic prevents the big fish from swallowing the small ones, and it does not apply to the small threats.

It is one of the strategies that small companies use to prevent big companies from taking them over. This unique name is one of the newest additions to the anti-takeover lexicons. This strategy perfectly works for all targeted companies that are cautious enough to include the clause of ‘lobster trap’ in the agreement. This trap is applicable for all sorts of convertible securities like convertible debentures, convertible preferred shares, convertible bonds, and convertible warrants.

Imagine a metaphorical lobster trap, where the target company strategically places financial instruments, poison pills, and complex contractual arrangements, creating a maze for any aspiring acquirer. Once the takeover bid is initiated, the maze becomes increasingly tricky to navigate, compelling the acquirer to reconsider the pursuit or face severe financial and operational constraints.

The lobster trap strategy is a testament to the creativity and resilience displayed by companies in protecting their autonomy. By complicating the takeover process, this defense aims to dissuade potential acquirers or extract favorable terms that safeguard shareholder interests.

However, the lobster trap defense is not without its limitations. Striking a delicate balance is crucial, as overly aggressive defensive measures may inadvertently harm shareholder value or impede the company’s growth potential. Moreover, regulatory scrutiny and shareholder activism can pose additional challenges to the successful deployment of the lobster trap defense.

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Examples

Now that we understand the basics of the lobster trap defense, let us apply the theoretical knowledge to practical application through the examples below.

Example #1

Let’s say HD company has been doing well in TV manufacturing. They’re new in the market, but they have been giving a serious threat to a significant player called BD & Co. On the other hand, 15% of the convertible securities of HD company is owned by a big company called Mitte Inc. Since a reasonable part is owned by Mitte Inc., it can be a matter of concern for HD company since big fish like BD & Co. can swallow them without much effort and using the securities of Mitte Inc.

Now, since HD company can see that BD & Co. can try to take over the company, they feel a serious threat. But the good news is while signing the agreement with Mitte Inc.; they included a clause stating that Mitte Inc. won’t be able to convert their securities into voting stock (think about the specificity of this trap where it’s mentioned that if a company or an individual owns over 10% of the convertible securities of the firm, the company or the individual won’t be able to convert the securities into voting stocks).

Since this clause is added, the HD company is now safe. And BD & Co. won’t be able to take over their new competition by straightforward means. It only happened because the management made a prudent decision when signing the agreement with Mitte Inc. This particular tactic saves the company from getting swallowed by the big fish called the lobster trap.

Example #2

In the 1980s, most publicly listed companies were filled with fear of the “corporate raiders” who were up and around making hostile takeover bids. Therefore, a lot of them started incorporating anti-takeover strategies to protect themselves from them.

Some of the most famous strategies included poison pills, golden parachutes, scorched-earth policies, and lobster traps. However, when the companies were pushed against the wall, they abandoned defensive strategies. They took the aggressive option of increasing the value of their shares to an extent where the party attempting to takeover found it unviable to do so.

Lobster Trap Defense Explained in Video

 

How Effective is It?

The effectiveness of the lobster trap strategy depends on how far-fetched the board of directors of a company can think. If a company becomes complacent and can’t see severe threats from its big competitors, it won’t be cautious and will easily swallowed by the big fish.

Like the example we saw above, the management was prudent enough to include a clause in the agreement that saved them from the big competitor. It’s important to know that this trap isn’t adequate for similar or small companies. It is only applicable to big and giant companies, preventing big companies from forcefully taking over a small business.

Why is the term ‘lobster trap’ added to the anti-takeover tactics lexicon?

The reason is simple. It’s precisely like catching lobster. The size of the lobster is prodigious. It has a vast cylindrical body, and the most crucial part is the first five pairs of lobster are transmuted into pincers. So, when this trap is created, it’s created to catch the lobster only and not the small ones.

That’s why only the big, giant lobster gets trapped in the trap and other small ones manage to escape. A lobster trap as an anti-takeover strategy does the same thing. It doesn’t take into account the small players. It only gets created to prevent the big fish from forcefully taking over the targeted company.

Why are Different Strategies like ‘Lobster Trap’ Created?

To be precise, the business world is not always the bed of roses. People do things that shouldn’t be done at all. In this age of collaboration and information overload also, many businesses use power and influence to persuade a smaller entity to do something that they never wanted to do in the first place.

  • One such thing is forcing smaller entities to surrender to a big fish’s power and influence. If the smaller entities don’t agree voluntarily, the big fishes turn to different unethical tactics to make them stoop down on their knees.
  • To save their small businesses from these giants and their unethical and forceful actions, these small entities follow one of many anti-takeover strategies so that they can fight till they can and prevent a hostile takeover.
  • It is one of many anti-takeover strategies that small firms use to be on the safest side.
  • The target companies also use tactics like a poison pill, golden parachute, scorched earth policy etc.

Advantages

Let us understand the advantages of incorporating the lobster trap defense through the points below.

  1. The most significant advantage of this trap is that it binds the owner of 10% or more convertible securities to a certain extent. It means the owner of these convertible securities or a big fish won’t take advantage of them.
  2. It won’t be easy for a big fish to take over the target company forcefully without owning more stocks.
  3. This trap can only be beneficial in hindsight. If it were not being done, it wouldn’t be effective. That means the effectiveness of this trap also lies in the efficiency of the top management.

Lobster Trap Vs Poison Pill

Let us discuss two of the most prominent anti-takeover measures adopted by corporates to prevent their companies being taken over by acquirers that do not take shareholders and company interest into their stride. We shall be able to understand the lobster trap defense through the comparison below.

Lobster Trap

  • Involves creating intricate financial structures to make it challenging for potential acquirers to extricate themselves once a takeover is initiated.
  • Utilizes complex contractual arrangements, financial instruments, and other sophisticated tactics to create a labyrinth for acquirers.
  • Discourages or hinders potential acquirers, forcing them to reconsider their pursuit or negotiate on less favorable terms.
  • Striking a balance is crucial to avoid harming shareholder value or hindering the company’s growth potential.

Poison Pill Defense

  • Involves issuing new shares or other securities to existing shareholders, making the takeover prohibitively expensive for the acquirer.
  • Triggers the dilution of shares or other financial consequences when a hostile takeover is attempted, making it financially unappealing.
  • Deters potential acquirers by increasing the cost and risks associated with the takeover, protecting shareholder interests.
  • Regulatory scrutiny and shareholder activism can challenge the successful deployment of poison pill defenses.

This article has been a guide to Lobster Trap and its meaning. Here we explain its examples and advantages, discuss its efficiency, and compare it with poison pill. You may also take a look at useful articles below

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