When Is Temporary Equity for Directors Not Temporary?

by Eric Feigenbaum

Temporary equity straddles the line between debt and equity financing. An investor is given shares of a company and often a board of directors seat in exchange for capital. However, an accompanying agreement has provisions entitling the company's founder's or directors to buy back the investor's shares at a pre-determined rate and time. Thus, the investor's equity is temporary and often seen as collateral for what is in essence, a loan.


Because temporary equity agreements use equity as collateral of what is really a business loan, the lender may keep the equity in case of a default. In a temporary equity situation, a default exists when the company or its key shareholders do not repay the loan by the date specified in their contract. Depending on the contract terms, a lender may get to keep her share of ownership in perpetuity.


Temporary equity agreements use dividends as a form of interest payments. Contracts typically entitle temporary equity holders to guaranteed dividends on a fixed schedule, much like preferred stock. If a company does not pay dividends as promised, it's essentially the same as a borrower not paying interest on a loan. A director and shareholder can claim the breach of contract constitutes a default and keep his share of interest in the company.


Depending on the contract terms and the individuals involved, breaches on a temporary equity agreement can lead to several things. In some cases, the lender and shareholder may be entitled to keep her shares permanently. In other situations, the lender may simply keep the shares for a longer period of time until the loan is repaid and continue collecting dividends. Although it's not common, a lender could demand additional equity in exchange for unpaid sums, which in certain situations would give her controlling interest in the company.


Like most business dealings, when temporary equity arrangements go bad, lawsuits are always possible. Lenders can sue for breach of contract and ask a court to award them additional money or equity beyond what a company is willing to offer. Alternatively, the lender/investor could ask for additional seats on the board of directors in an attempt to take a larger management role and push the company into profitability. By bringing in experts and trusted advisers of his own, some directors and owners feel their interests will be better guarded.