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Preferred Stock (Convertible vs. Participating Returns)

Guide to Understanding Preferred Stock

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Preferred Stock (Convertible vs. Participating Returns)

Preferred Stock Features

Like common stock, preferred stock is a class of ownership in the issuing company. These securities sit above common equity in the capital structure, in terms of the priority at which security holders are entitled to a portion of the company’s profits.

Still, preferred stock is of lower priority than all tranches of debt, including the riskier types of debt such as mezzanine financing.

The risk/return profile of preferred stock tends to appeal most to institutional investors attempting to maximize the potential upside while limiting the downside.

Types of Preferred Stock

Convertible vs. Participating Preferred Returns

Two of the more frequent types of preferred stock investment structures are the following:

  1. Convertible Preferred → In the case of convertible preferred stock, the holder is granted the right to receive either the preferred proceeds or the post-conversion equity value. For the latter option, whichever is of greater value and brings higher returns to the investment firm is chosen.
  2. Participating Preferred → On the other hand, for participating preferred stock, the firm receives the preferred proceeds amount (i.e., the cash dividends or accrued value), as well as a portion of the residual proceeds for common equity shareholders – so, the investor gets to “double-dip” in the exit proceeds.

Preferred Stock Calculator – Excel Model Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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Step 1. Preferred Stock Investment Assumptions

Suppose a private investment firm has decided to invest $100 million for a 20% ownership stake in the target company.

  • Capital Invested = $100 million
  • % Implied Ownership = 20%

The company holds zero debt on its balance sheet (i.e. 100% preferred and common equity) from the date of initial purchase to the date of exit.

Upon dividing the $100mm of capital invested by the 20% ownership, the implied total equity value of the target is $500mm. As a placeholder, the exit proceeds (i.e., the exit equity valuation) are $1 billion.

  • Entry Equity Value = $500 million
  • Exit Proceeds = $1 billion

Step 2. Convertible Preferred Stock Returns Calculation

In the next part of our exercise, we’ll begin setting up the calculation for the convertible preferred stock returns given the stated scenario.

  • Preferred Value → The preferred value formula contains a “MIN” function that links to the original $100mm capital investment and the value of the exit proceeds. The reason for this is that if the exit equity value is less than the preferred investment, the investors cannot receive the initial amount back in full (i.e., incurred a net loss).
  • Convertible Value → The convertible value equals the implied ownership multiplied by the exit proceeds.

Since the convertible preferred stock chooses the higher value, we use the “MAX” function between the preferred value and convertible value.

Therefore, the convertible value of $200mm is selected as it is the greater of the two compared to the $100 million received from the preferred value.

Under the $1 billion exit scenario, the convertible value comes out to $200mm.

Conversion Ratio and Convertible Price

In practice, convertible preferred stock comes with a pre-negotiated conversion ratio, which determines the number of common shares received per preferred share upon conversion.

After multiplying the number of preferred shares by the conversion ratio, we can calculate the number of convertible common shares.

Then, the conversion price can be calculated by dividing the par value of the convertible preferred stock by the number of common shares that could be received.

Moving on, the assumption here is that the $100 million preferred investment can be converted into 20% of the total common equity.

Since we have the entry valuation, we can deduce that the inflection point where the convertible value exceeds the preferred value will be an exit valuation in excess of $500mm (i.e., 5x initial).

Once past the break-even point, the convertible shares are considered to be “in-the-money” and profitable to convert.

As an example, say the exit value falls to $50mm from the initial valuation of $500mm. That would mean the valuation has fallen 90%. By multiplying the $50mm in exit proceeds by 20%, we get $10mm as the convertible value.

The convertible value is $10mm while the preferred value is $50mm; hence, the preferred value is chosen. This $50mm in proceeds reflects the downside protection of preferred stock.

And after calculating the proceeds, we can back out the multiple on invested capital (“MOIC”) by dividing the proceeds received by the initial investment. For instance, if the exit proceeds are $1bn, the convertible value is $200mm, which represents a 2.0x MOIC.

  • MOIC = $200mm ÷ $100mm = 2.0x

Step 3. Participating Preferred Stock Returns Calculation

The “participating” portion of participating preferred stock refers to being able to share in the residual shares left for common shareholders after receiving the preferred value.

In contrast, for “non-participating” preferred equity, the investment firm receives just the preferred value without being entitled to any of the common proceeds – the exception being if there is a convertible feature attached.

Usually, preferred equity pays out dividends in either cash or paid-in-kind (“PIK”), but we are neglecting them here for the sake of simplicity.

  • Preferred Value → To calculate the preferred value, we’ll deduct the value of the preferred equity from the exit proceeds, as well as wrap a “MAX” function around the formula to ensure the value does not dip below zero. The preferred value is the first source of proceeds for the investor.
  • Participating Value →  Since the investment here is structured as participating preferred, the investor has a 20% share of the residual common equity value.

For example, the $900mm in common equity proceeds is multiplied by 20% to get $180mm.

The sum of the two sources results in $280mm as the total proceeds received under the participating preferred stock investment (and an implied 2.8x MOIC).

  • Proceeds to Firm, Participating Preferred = $100 million + $180 million = $280 million
Preferred vs. Common Equity Returns

The preferred equity holders are above common equity holders in terms of the order of priority in which they are paid out.

Hypothetically, in an unfavorable exit scenario, the common equity holders can be left with no residual proceeds. But while the common equity holders could be left with nothing, they are typically not at risk of owing anything to the company (i.e. negative proceeds).

The treatment of preferred equity when calculating the remaining proceeds to common equity holders is debt-like, in the sense that the preferred equity holders get paid out first before the common equity holders are entitled to any proceeds.

Step 4. Preferred Stock Returns Analysis

In the two sensitivity tables placed below our returns model, we can see the proceeds to the firm and the MOIC based on different exit proceeds.

The returns from the participating preferred structure outpace that of convertible preferred investments most of the time.

For that reason, companies limit the % share that preferred investors have in the proceeds attributable to common shareholders, and/or place a liquidation preference cap on the return multiple to prevent the investor from generating returns beyond a certain level (and such provisions help protect existing common shareholders from dilution).

Preferred Stock Calculator

Step 5. Convertible vs. Participating Preferred Stock Returns Graph

In closing, we benchmark the two returns against one another in the illustrative graph below, depicting how the convertible value remains constant at $100mm until the exit proceeds reach $500mm.

Convertible vs. Participating Preferred Stock Returns

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