A Simple Model Leveraged Model: Adding Preferred

NOTES TO ACCOMPANY VIDEOS These notes are intended to supplement the videos on ASimpleModel.com. They are not to be used as stand‐alone study aids, and are not written as comprehensive overviews of the topic detailed. The purpose of these notes is to provide a tangible collection of the visuals used in the videos with comments highlighting the more important aspects covered.

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Preface to Notes: At times I find it is easier to explain a new concept by limiting the number of variables in the model, but it doesn’t necessarily mean that what is modeled is practical. In this video, to introduce preferred stock, I reduce common to zero and move the entire balance to preferred stock to make the instruction easier to follow. I want to emphasize that you are not likely to find a company with this equity structure. A company that has issued preferred stock has generally issued common stock as well. You are also unlikely to have preferred stock issued with warrants attached that, once exercised, provide the right to purchase 100% of the common shares. The intention of this video is not to present a realistic equity structure. The objective is to focus on the mechanics of adding preferred stock to a financial model, and explain why it is important to know if any associated dividend is paid in cash or accrued, and explain why it is important if the preferred shares are convertible or offered with warrants. The materials associated with this video provide a condensed overview of preferred stock highlighting only the most important characteristics to be aware of when you are building a simple leveraged buyout model.

Vocabulary: Preferred Stock - A class of ownership that has a claim on the assets and earnings of a business ahead of common stock. Preferred stock is issued with a face value and generally pays or accrues a dividend as a percent of face value. Convertible Preferred Stock – If the shares of preferred stock issued are convertible, it means that at the of the holder, or the option of the board of directors, or at a predetermined date, the preferred stock shares can be converted into shares of common stock. • Assume you hold one share of convertible preferred stock issued at $1,000 that has a conversion privilege stating you can convert your share of preferred stock into 100 shares of common stock. If the value of common starts trading above $10 ($1,000/100) you might consider converting. Warrants – As it relates to this video, a provides the right to purchase a security at a predetermined price. Preferred stock can be issued with warrants attached permitting the purchase of common stock. • Warrants, like options, are issued with a strike price (or exercise price) and expiration date. When a business is sold (exit year in the LBO model), the warrants are sold for the value per share of the common stock less the exercise price. This video instruction, and the associated financial template, do not account for the exercise price. This is an oversimplified approach, and assumes an exercise price of zero.

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Video: As we continue to move forward with this series, I intend to emulate (as much as possible) exercises as you might experience them on the job. Most instructional videos, including many on this website, work through the entire model from beginning to end in perfect sequence. This is helpful because it teaches you an order that helps novices think about the structure of a financial model, but a lot of financial modeling real-world exercises do not take this approach. Whether you are building your own template, or working with a pre-established template, eventually most of the changes you make will be updates or edits. That is the approach described here. You might, for example, evaluate a transaction and conclude that the scenarios you are running through the model have changed, and that the limited partners (LPs) are to be offered preferred stock in place of common stock. In this situation it would be a terrible use of your time to rebuild the model, and this is precisely why it is so important to understand how everything is linked. Adding preferred stock to the model is reduced to a quick exercise if you know how all of the financial statements and supporting schedules will be impacted before you even get started. In this exercise, the financial statements and schedules requiring updates are as follows (worksheets requiring updates are indicated by purple shading):

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In this video we introduce preferred stock: a class of ownership that has a claim on the assets and earnings of a business ahead of common stock. Preferred stock generally pays or accrues a dividend. So while it is viewed as a safer security, because its claims on the business are senior to those of common shareholders, it may have more limited upside. Preferred stock, however, may be offered with a variety of terms. In an LBO transaction it is not uncommon to see preferred stock offered with the potential for additional participation in the ownership of the business. To achieve this objective preferred stock is typically offered one of two ways: 1. As a convertible security (preferred shares can be exchanged for common shares). 2. With warrants attached (the right to purchase common shares at a predetermined price). In the video and in the associated Excel file, the second option is modeled. You will notice on the Exit Analysis tab that in the return profile the sum of preferred stock and accrued dividends are returned to the investor (see red box):

In addition to principal redeemed, the investor also benefits from warrants, which once exercised, provide the right to purchase 100% of the common shares. I want to emphasize that this is not a realistic scenario. It was modeled this way to make the instruction easier to follow and to highlight the difference between (1) preferred stock with warrants attached, (2) convertible preferred stock, and (3) common stock. In the video example, had the preferred stock issued been convertible, the line for “Principal Repayment” in the image above would show a value of zero. This is less attractive to an investor because the distributions associated with the return of principal and accrued dividends are senior to distributions associated with common ownership. To illustrate the difference between preferred stock with warrants and common stock, we will walk through an example on the page that follows.

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Self-Study Exercise: To understand the difference go through the following steps in the model: 1. Adjust the Sources and Uses tab so that inputs for Common and Preferred Stock each equal half of the total equity raised. 2. Adjust the Exit Analysis tab so that both Common and Preferred Stock have a 50% ownership position. What you will notice is that the 50% of equity proceeds is calculated after the face value of preferred stock and accrued dividends have been subtracted from the balance.

Value of preferred stock and accrued dividends subtracted from proceeds.

50% Warrants + Principal Repayment

For this reason, the preferred stock with warrants will be more valuable than common stock in this model. To quantify this difference take a look at the return profiles (green boxes). It is also the reason that you should pay very close attention to offerings. Small differences in language can be incredibly meaningful.

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This begs the question: What additional vocabulary should I be aware of as it relates to preferred stock offerings? There are a lot of variations, but as it relates to financial modeling whether or not it converts and how the dividend is paid are possibly the most important. With respect to the latter, you may have noticed in the video that there is an option to pay a cash dividend or a Payment-in-Kind dividend. 1. Cash dividends are straightforward. Here the shareholder receives the dividend, as a percentage of face value, in cash. 2. Payment-in-Kind dividends are accrued as additional securities of the same class. This is a good place to revisit some of the changes made to the model. To adjust the LBO template for the payment of dividends very few adjustments were made to the financial statements, and there are really only three changes that we need to focus on to understand how the model balances ( equation holds true). 1. First, we added a line on the balance sheet under the equity account for preferred stock. When dividends are paid in cash, this line item remains constant. PIK dividends, however, increase the face value of preferred stock. 2. Second, we subtracted both cash and PIK dividends from retained earnings. Recall that on the debt schedule the calculation works out such that only one of the two types of dividends is paid. Regardless of which is paid, however, the value of retained earnings is reduced. 3. Third, we included a line for cash dividends under cash flow from financing activities. (Notice that there is no line for PIK dividends on the cash flow statement.) So when a PIK dividend is accrued, the face value of preferred stock increases on the balance sheet under the equity account, and retained earnings is reduced by the same amount. The net effect on the equity account is zero and the model remains balanced. When a cash dividend is paid, the face value of preferred stock remains constant on the balance sheet under the equity account, but Retained Earnings is still reduced by the amount of the dividend. To keep the balance sheet balanced, cash is reduced on the cash flow statement by the amount of the dividend under cash flow from financing activities. This reduced cash balance links back to cash on the balance sheet, which balances the model.

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Some Notes on Preferred Stock in Financial Templates There are a few things that might appear confusing about preferred stock in financial models. First, because it behaves partially like a debt instrument, it is common to see the supporting schedule for preferred stock on the debt schedule. For this reason you might also see the yield (or dividend) associated with preferred stock labeled as “interest” in a financial model. To be clear, preferred stock does not pay interest, it pays dividends only. Also, you may see the PIK dividend added back on the cash flow statement under cash flow from operating activities. When you see this you can generally scroll up to the income statement and find a line following net income titled “net income after dividends,” or something similar. While it is common to see this in financial models, dividends do not run through the income statement. The model balances, however, because this approach also affects retained earnings (recall that retained earnings grows by net income).

More on Preferred Stock to Follow… Preferred stock will be discussed further in the videos that follow. For the time being, and as it relates to financial models, this is a condensed introduction. In future videos we will also touch on more realistic equity structures.

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