which are subject to various limits, and include substantial deductibles or self-insured retentions. Special insurance is sometimes obtained with respect to specific hazards, if deemed appropriate and available at a reasonable cost. Claims in excess of, or not included within, KLC's coverage may be asserted or coverage may not be available due to insurance company failures or other reasons. KLC OpCo maintained either a self-insured retention or a deductible for a portion of its general liability, workers' compensation, auto, property and employee medical insurance programs. It purchases stop loss coverage in order to mitigate its potential future losses. The nature of these liabilities, which may not fully manifest themselves for several years, requires significant judgment. KLC OpCo estimates the obligations for liabilities incurred but not yet reported or paid based on available claims data and historical trends and experience, as well as future projections of ultimate losses, expenses, premiums and administrative costs. While the company believes that the amounts accrued for these obligations are sufficient, any significant increase in the number of claims and/or costs associated with claims made under these programs could have a material adverse effect on the consolidated financial statements. 11.13. Legal Issues KLC OpCo does not believe that there are any pending or threatened legal proceedings that, if adversely determined, would have a material adverse effect on its business or operations. However, it is subject to claims and litigation arising in the ordinary course of business, including claims and litigation involving allegations of physical or sexual abuse of children. Although KLC OpCo cannot be assured of the ultimate outcome of the allegations, claims or lawsuits of which it is aware, it has not historically had to pay any claims exceeding its insurance coverage, and management believes that none of these allegations, claims or lawsuits, either individually or in the aggregate, will have a material adverse effect on the Company's financial position, operating results or cash flows. In addition, it cannot predict the negative impact of publicity that may be associated with any such allegation, claim or lawsuit. 91 11.14. Real Estate As a result of a November 9, 2005 Real Estate Transaction, substantially all of the real estate owned by KLC OpCo was transferred to KLC PropCo. Although the expectation is that newly acquired real estate will be owned by KLC PropCo and leased back to KLC OpCo, KLC OpCo continues to be actively involved in new center design, development and management. In addition to development of new centers, the team is responsible for maintaining existing centers. The real estate group within KLC OpCo is headed by Wayne Pipes, Vice President. 11.15. Environmental KLC OpCo is not aware of any existing environmental conditions that currently or in the future could reasonably be expected to have a material adverse effect on its financial position, operating results or cash flows. It has not incurred material expenditures to address environmental conditions at any property. However, it has not undertaken an in-depth environmental review of all of its owned and leased centers. Consequently, there may be material environmental liabilities of which it is unaware. In addition, future laws, ordinances or regulations may impose material environmental liability, and the current environmental condition of the centers may be adversely affected by conditions at locations in the vicinity of those centers (such as the presence of leaking underground storage tanks) or by third parties unrelated to the company. 11.16. Summary Financial Information and Projections Discussion The following summary historical and projected financial data should be read in conjunction with the financial statements and "Management's Discussion and Analysis of KLC's Pro Forma Results of Operations" presented elsewhere in this Memorandum. See also "Non-GAAP Financial Measures" elsewhere in this Memorandum for a discussion of the derivation and limitations of Adjusted EBITDA and Adjusted EBITDAR. The historical information is pro forma for the effects of the acquisition of KinderCare in January 2005 and the separation of KLC into KLC OpCo and KLC PropCo in November 2005, as if those transactions and related financing had occurred on January 1, 2004. KLC OpCo's pro forma results reflect KLC's consolidated pro forma results adjusted to include $96.3 million of rent expense payable to KLC PropCo. Projected results presented below are based on assumptions management believes to be reasonable, but which are inherently uncertain and may not be realized. KLC OpCo's ability to perform as projected depends on a number of variables that cannot be predicted with certainty and actual performance could be adversely affected by a number of factors, including those described in "Risk Factors," particularly the risk factor related to projections elsewhere in this Memorandum. Also see "Forward-Looking Statements." 92 KLC OpCo Summary Historical Pro Forma and Projected Financials ($ in millions) Fiscal Year Ended December 31, 2004PF 2005PF 2006P 2007P 2008P 2009P 2010P 2011P OPERATIONAL DATA Revenue $1,442.2 $1,477.7 $1,557.8 $1,656.5 $1,769.6 $1,919.7 $2,095.8 $2,290.8 Growth 2.5% 5.4% 6.3% 6.8% 8.5% 9.2% 9.3% Gross Profit $233.3 $244.4 $290.7 $320.6 $354.0 $396.2 $448.2 $501.3 Adjusted EBITDA $143.3 $149.9 $161.7 $179.9 $204.8 $237.5 $279.0 $320.1 Margin 9.9% 10.1% 10.4% 10.9% 11.6% 12.4% 13.3% 14.0% Adjusted EBITDAR $352.8 $367.4 $371.4 $391.4 $419.6 $459.7 $510.8 $568.6 Margin 24.5% 24.9% 23.8% 23.6% 23.7% 23.9% 24.4% 24.8% Operating Income $27.1 $78.9 $101.6 $117.8 $146.9 $179.5 $212.4 Total Interest Expense 23.5 23.6 23.5 23.4 23.3 23.1 22.9 Net Income' $1.6 $31.1 $46.0 $56.9 $77.4 $98.3 $117.9 BALANCE SHEET DATA Cash $118.8 $154.2 $215.8 $288.5 $373.7 $484.8 $621.2 Accounts Receivable 55.6 58.6 62.4 66.6 72.3 78.9 86.2 PP&E, Net 286.6 301.9 305.9 309.4 315.0 315.6 311.1 Accounts Payable 13.0 13.7 14.6 15.6 16.9 18.4 20.1 SELECTED CASH FLOW DATA Net Income (Loss)1 $1.6 $31.1 $46.0 $56.9 $77.4 $98.3 $117.9 + Depreciation 47.9 54.6 56.2 61.5 67.3 74.2 80.9 + Amortization of Intangibles 11.6 12.8 10.0 8.8 3.6 3.5 3.5 + Amortization of Deferred Financing Fees 0.8 0.8 0.8 0.8 0.8 0.8 0.8 + Change in Working Capital2 0.0 2.8 3.4 3.9 5.2 6.1 6.8 + Change in Accrued LTIP2 0.0 2.6 4.0 4.5 2.4 1.1 0.6 + Change in Accrued SAW 9.9 2.1 3.1 3.2 3.7 4.7 5.6 + Change in Other Assets 0.0 (0.6) (0.8) (0.9) (1.2) (1.4) (1.5) = Operating Cash Flow $71.9 $106.0 $122.7 $138.7 $159.3 $187.4 $214.5 - Capital Expenditures (83.1) (69.9) (60.2) (65.0) (72.8) (74.8) (76.4) - Capitalized Lease Payments (0.5) (0.8) (0.9) (1.0) (1.3) (1.5) (1.7) = Cash for Debt Service $(11.7) $35.4 $61.6 $72.7 $85.2 $111.1 $137.9 CAPITALIZATION Total Debt $276.4 $275.6 $274.7 $273.7 $272.5 $271.0 $269.3 Shareholders' Equity' 254.1 283.1 330.1 390.7 474.8 583.6 721.1 Total Capitalization $530.5 $558.7 $604.9 $664.4 $747.3 $854.6 $990.4 Excludes equity in earnings of unconsolidated subsidiary (KLC PropCo). KLC has not divided change in working capital between KLC OpCo and KLC PropCo. Traditionally KLC OpCo operates with positive working capital. 3 For additional detail, see the discussion below under the heading "- Long Term Incentive Plan." 4 Non-cash expenses related to KSI's Stock Appreciation Rights Plan attributed to KLC's employees and payable by KSI in cash upon settlement. 5 Represents book value. Revenue Management projects revenue to increase at a 8.0% CAGR, from $1.6 billion in 2006 to $2.3 billion in 2011. Most of the projected growth stems from KLC OpCo's ECE segment which currently accounts for approximately 96.0% of KLC OpCo's pro forma revenue. The following table shows projected revenue by business segment: 93 KLC OpCo ($ in millions) 2006P 2007P 2008P 2009P 2010P 2011P ECE Centers $1,488.7 $1,572.8 $1,668.4 $1,797.1 $1,947.4 $2,111.1 School Partnerships 55.5 66.6 79.9 95.9 115.1 138.1 KC Distance Learning 13.6 17.1 21.3 26.7 33.3 41.6 Total Revenue $1,557.8 $1,656.5 $1,769.6 $1,919.7 $2,095.8 $2,290.8 Sales Growth From 2006 to 2011 KLC OpCo projects that revenue from the ECE centers will grow at a 7.2% CAGR. The growth forecast is based on the following assumptions: . Tuition growth. KLC OpCo projects that tuition rates at existing centers will grow at approximately 4% per year for the next five years. This growth is below recent experience (6.9% in 2005). Moreover, tuition rates in the industry have been growing at average rates of greater than 4%. r. Utilization improvement. Management projects that recent improvements witnessed at KLC OpCo will continue. By 2011, KLC OpCo projects Utilization will have increased to 65.2%. Management believes these improvements in Utilization will be the result of expected favorable demographic trends (described elsewhere in this Memorandum), new sales training programs, re-branding efforts in selected markets combined with the opening of appropriately sized centers. . New centers. KLC OpCo expects a net reduction of centers in 2006 and 2007 as it completes its integration of KinderCare and the rationalization of its properties. Beginning in 2008, KLC OpCo projects to be adding net centers. KLC OpCo 2005PF 2006P 2007P 2008P 2009P 2010P 2011P Utilization 61.2% 62.2% 63.0% 63.5% 63.9% 64.5% 65.2% Average Weekly Tuition $167.35 $173.68 $179.99 $188.37 $197.47 $206.95 $216.52 % Growth 3.7% 3.6% 4.7% 4.8% 4.8% 4.6% Center Count Beginning of Period 2,021 1,934 1,894 1,878 1,890 1,925 1,963 New Center Additions 10 10 24 52 75 78 80 Closures (97) (50) (40) (40) (40) (40) (40) End of Period 1,934 1,894 1,878 1,890 1,925 1,963 2,003 Additional Products and Services KLC OpCo plans to use its footprint of approximately 2,000 centers across the U.S. as a platform to sell additional educational (e.g., supplemental phonics, math, Spanish and music courses) and non- educational (e.g., health insurance, childcare financing) products and services. The sale of additional products and services is expected to generate approximately 2.2% of total revenue in 2011, which is included in the ECE center projections. 94 School Partnerships School Partnerships is projected to grow from $48.5 million in pro forma revenues in 2005 to $138.1 million in 2011. As a percentage of revenue, School Partnerships accounts for 3.3% of total pro forma revenue in 2005, and is projected to grow to 6.0% in 2011. KLC OpCo projects that growth in the School Partnerships business will be primarily driven by growth in the SES market (more school districts required to offer supplemental services), and an increase in the number of parent pay locations in the U.S. KC Distance Learning KCDL is projected to grow from $10.0 million in pro forma revenues in 2005 to $41.6 million in 2011. As a percentage of revenue, KCDL accounts for 0.7% of total pro forma revenue in 2005, and is projected to grow to 1.8% in 2011. KLC OpCo projects that growth in this line will predominantly come from the expansion of KCDL's direct to family business (which currently accounts for approximately 90% of pro forma revenue) and the expansion of states to digital high school courses (which KLC believes it is in a position to provide on an outsourced basis). Gross Margin KLC OpCo's pro forma gross profit is projected to increase from $244.4 million in 2005 to $501.3 million in 2011. The growth in gross profit is projected to be largely driven by increased center efficiency as a result of improved Utilization, continued tuition increases and the closure of underperforming centers and shift in the revenue mix to more profitable business lines (Le., more employer-sponsored centers, KCDL, ancillary products and services). KLC OpCo's gross margin is projected to improve from approximately 16.5% of total revenues in fiscal year 2006 to 21.9% in fiscal year 2011 as a result of these factors. Selling, General and Administrative Expenses Due to the relatively fixed nature of KLC OpCo's selling, general and administrative (SG&A) expenses, KLC OpCo projects that SG&A will increase at a rate of 4.5% annually after 2006. Additionally, management estimates that there will be a one-time increase of $2.0 in SG&A related to the expansion of the SES business in 2007. Adjusted EBITDA and Adjusted EBITDA Margins KLC OpCo projects improving pro forma Adjusted EBITDA from $149.9 million in fiscal year 2005 to $320.1 million in fiscal year 2011. Pro forma Adjusted EBITDA margin is expected to improve from 10.1% in fiscal year 2005 to 14.0% in fiscal year 2011. This projected margin improvement reflects the combination of increasing sales and margin improvements outlined above. The table below shows the calculation of pro forma Adjusted EBITDA. 95 KLC OpCo 2007P 2008P 2009P 2010P 2011P EBITDA $86.6 $146.3 $167.8 $188.1 $217.8 $257.1 $296.8 Adjustments to EBITDA Restructuring Charge Addbackl $29.4 $6.3 $0.0 $0.0 $0.0 $0.0 $0.0 (Gains) / Losses on Sales2 (1.3) 0.0 0.0 0.0 0.0 0.0 0.0 Dividend Income3 (0.5) 0.0 0.0 0.0 0.0 0.0 0.0 SAR Plan4 9.9 2.1 3.1 3.2 3.7 4.7 5.6 Estimated Parallel Organization Costs6 23.3 2.0 0.0 0.0 0.0 0.0 0.0 Management Fee6 2.5 2.5 2.5 2.5 2.5 2.5 2.5 Long Term Incentive Plan' 0.0 2.6 6.6 11.1 13.5 14.6 15.2 Adjusted EBITDA $149.9 $161.7 $179.9 $204.8 $237.5 $279.0 $320.1 1 Represents one-time non-recurring costs of integrating AER and KinderCare acquisitions in 2004 and 2005 respectively. 2 Represents the non-cash impact of (gains) / losses on the sale of centers. 3 Income earned as a result of ownership in a minority investment. a Represents accruals related to KSI's SAR plan. Approximately $7.8 million has been paid pursuant to SARs in connection with the departure of KLC's chief executive officer in 2006. 5 Result of the costs of operating duplicative infrastructure at KLC and KinderCare following the KinderCare acquisition. 6 Management fee paid to affiliate entities. 7 For more information, see the discussion below under the heading "- Long Term Incentive Plan." Long Term Incentive Plan Our Adjusted EBITDA projections do not include the effect of any payments that may be made pursuant to our Long Term Incentive Compensation Plan. Under this new plan, which provides performance-based incentive compensation awards beginning in 2006 based on our performance against specific Adjusted EBITDA targets, we will accrue expenses ranging from $2.6 million in 2006 to $15.2 million in 2011 if our Adjusted EBITDA meets the projections set forth in this Memorandum. Each award is payable at the end of three years based on performance and subject to continued employment (with certain exceptions). The accrued expenses associated with an award in each period are non-cash, subject to cash settlement when and if the award for that period is earned at the end of the third year. The actual expenses could be higher or lower depending on whether actual Adjusted EBITDA performance exceeds or is less than the amounts projected herein. Working Capital KLC OpCo does not expect revenue or expenses to have a meaningful impact on working capital ratios in the future. 96 Capital Expenditures The following table shows the breakdown in KLC OpCo's projected capital expenditures: KLC OpCo ($ in millions) 2006P 2007P 2008P 2009P 2010P 2011P Maintenance $41.1 $40.8 $41.0 $41.8 $42.6 $43.5 New Centers (Furniture, Fixtures &Equipment) 10.1 7.2 15.6 22.5 23.4 24.0 IT Spending and Other Capex 18.6 12.2 8.4 8.6 8.8 9.0 Total Capital Expenditures $69.9 $60.2 $65.0 $72.8 $74.8 $76.4 Between 2006 and 2011, KLC OpCo projects to spend between $41 million and $44 million annually on maintenance capital expenditures (approximately $22,000 on a per center basis), which includes refurbishment of its existing centers and equipment and supplies replacement costs. In addition, KLC OpCo expects to spend approximately $19 million in 2006 on corporate infrastructure improvements, primarily IT spending. The remainder of KLC's OpCo capital expenditures is projected to be used to expand KLC OpCo's center base. Beginning in 2007 KLC projects that it will only open leased centers; KLC OpCo believes that its cost of furnishing each center will be approximately $300,000 per center. 11.17. Debt Summary The table below shows KLC OpCo's outstanding debt as of December 31, 2005. KLC OpCo Debt Capitalization ($ in millions) 12/31/05 Cash $118.8 Revolverl $0.0 Capital Leases 16.4 Senior Subordinated Notes 260.0 Total KLC OpCo Debt $276.4 Net Debt2 $157.6 1 KLC OpCo has a $100 million revolver, primarily used to support outstanding letters of credit. 2 Represents total debt less cash. 11.18. Terms of Revolving Credit Facility In November 2005, KLC entered into a revolving credit facility (the "Revolver") with a syndicate of financial institutions consisting of a $100.0 million five-year revolving credit facility under which revolving and swingline loans may be made, and letters of credit may be issued in amounts up to $75.0 million. The Revolver is used for KLC's working capital and general corporate requirements. At December 31, 2005, KLC had no revolving loans outstanding and approximately $46.6 million in letters of credit outstanding under the Revolver. KLC pays a commitment fee equal to 0.50% per annum on the undrawn portion available under the Revolver and a fee of 1.25% per annum of the daily amount available to be drawn under outstanding letters of credit. 97 Borrowings under the Revolver will generally bear interest based on a margin over, at KLC OpCo's option, either the base rate (generally the applicable prime lending rate, as announced from time to time) or the reserve adjusted LIBOR rate. The applicable margin for revolving loans will be 0.25% for base rate loans and 1.25% for reserve adjusted LIBOR loans. KLC is permitted to voluntarily prepay principal amounts outstanding or reduce commitments under the Revolver at any time, in whole or in part, without premium or penalty. The Revolver is fully and unconditionally guaranteed by KSI and on a joint and several basis by most of KLC's direct and indirect domestic subsidiaries within KLC OpCo. The Revolver and guarantees are secured by first priority security interests in, and liens on, substantially all of KLC OpCo's and the guarantors' assets and first priority pledges of all the equity interests owned by KSI in KLC and owned by KLC in its direct and indirect domestic subsidiaries in KLC OpCo and 66% of the equity interests owned by KLC in its non-domestic subsidiaries. The revolving credit facility contains customary affirmative and negative covenants for financings of its type (with customary exceptions). The financial covenants include: a minimum fixed charge coverage ratio test; a minimum leverage ratio test; a minimum interest coverage ratio test; and a minimum EBITDA test. Operating covenants limit KLC's and its restricted subsidiaries, and in certain cases, KSI's ability to (among others): incur additional debt; incur liens or other encumbrances; make investments; make acquisitions; incur certain contingent liabilities; make certain restricted junior payments and other similar distributions; enter into mergers, consolidations and similar combinations; sell assets or engage in similar transfers; open new learning centers; engage in transactions with affiliates; enter into sale-leaseback transactions; engage in businesses other than those in which KLC and its restricted subsidiaries and KSI were engaged at the time of the closing of the Revolver and other related or ancillary businesses; amend certain material agreements; prepay subordinated debt; sell or discount receivables; and dispose of any equity securities in its subsidiaries. 11.19. Terms of Senior Subordinated Notes In February 2005, KLC sold $260.0 million in aggregate principal amount of PA% Senior Subordinated Notes due February 1, 2015 (the "Notes") in connection with the KinderCare acquisition and related financing transactions. The Notes bear interest at the rate of VA% per year, payable semi-annually, in arrears, on February 1 and August 1 of each year. KLC may redeem the Notes, in whole or in part, on or after February 1, 2010 at certain pre-set redemption prices, plus any accrued and unpaid interest. On or prior to February 1, 2010 KLC may redeem the Notes in whole, but not in part, at a redemption price equal to 100% of the principal amount of the Notes to be redeemed plus an applicable premium. In addition, on or prior to February 1, 2008 KLC may redeem up to 35% of the aggregate principal amount of the Notes with the net proceeds of one or more qualified equity offerings. Subject to KLC's right to redeem the Notes, upon a change of control event, holders of the Notes may require KLC to repurchase all or a portion of the Notes at a purchase price of 101% of their principal amount, plus accrued and unpaid interest. KLC's obligations under the Notes are fully and unconditionally, and jointly and severally, guaranteed on a senior subordinated basis by most of KLC's domestic restricted subsidiaries within KLC OpCo. The indenture governing the Notes contains covenants that limit KLC and its restricted subsidiaries' ability to, among other things: (a) pay dividends, redeem capital stock and make other restricted payments and investments; (b) incur additional debt or issue preferred stock; (c) enter into agreements that restrict KLC subsidiaries from paying dividends or other distributions, making loans or otherwise transferring assets to 95 KLC or to any other subsidiaries; (d) create liens on assets; (e) engage in transactions with affiliates; (f) sell assets, including capital stock of subsidiaries, except permitted real estate transfers and other permitted transfers; and (g) merge, consolidate or sell all or substantially all of KLC's assets and the assets of KLC's subsidiaries except permitted real estate transfers and other permitted transfers. 11.20. Stockholders Agreement of Knowledge Schools, Inc. KLC is a wholly owned subsidiary of KSI, and KSI pursues no other businesses independent of holding KLC's stock/equity. KSI entered into a Stockholders Agreement on May 9, 2003 with Knowledge Universe Learning Corp. (the "KSI Parent") and its minority stockholders (the "Stockholders"). The Agreement provides (a) the KSI Parent (and/or any "Parent Entities" designated by the KSI Parent, which include the KSI Parent and/or certain of the Principals and certain affiliates of the KSI Parent and the Principals) with a right of first refusal over proposed transfers of other Stockholders' shares, subject to certain exceptions; (b) Stockholders, to the extent they are accredited investors, with a right to invest in new issuances of KSI shares; (c) Stockholders with tag-along rights in connection with a transfer of KSI common stock by any of the Parent Entities resulting in the Parent Entities owning less than 60% of KSI common stock then outstanding, or a transfer of securities by any of the Parent Entities resulting in the Parent Entities owning less than a majority of KSI common stock then outstanding. Stockholders are also subject to a drag-along provision, pursuant to which they may be required to sell a pro rata portion of their shares in the event of a proposed transfer of a majority of KSI common stock then outstanding. Each Stockholder and the KSI Parent are entitled to receive certain financial information from KS]. The Agreement terminates upon a public offering of KSI, at the option of the KSI Parent upon a sale of KSI, or by written agreement of the parties. Knowledge Universe Learning Corp. was liquidated on October 27, 2004 and the shares of KSI were distributed on that date to its sole stockholder, KUE Inc. 99 12. THE REAL ESTATE COMPANY ("KLC PROPCO") On November 9, 2005, KLC transferred ownership of 845 ECE centers into wholly owned, bankruptcy remote subsidiaries, which are referred to as KLC PropCo. In October 2005, 713 of the centers were independently appraised at approximately $1.1 billion.36 KLC PropCo then issued $700 million of CMBS debt secured by the 713 appraised centers and the stock of the CMBS borrower, and $150 million of junior mezzanine debt, the proceeds of which were used to repay KLC OpCo debt. The table below summarizes the revised corporate structure at KLC: KLC OpCo • $100.0 million Revolver • $16.4 million Capital Leases • $260.0 million Sr. Subordinated Notes Operating Company 77.-------- • 845 Properties • $699.4 million CMBS Debt K.... • $150.0 million Junior Mezzanine Debt(” KLC PropCo Represents face value; book value is approximately $147.3 million. Real Estate Company With 845 ECE centers in 37 states (as of December 31, 2005), KLC PropCo believes it is the largest private owner of education real estate assets in the world. The real estate portfolio is geographically diversified without significant concentrations or ties to any single part of the U.S. KLC PropCo leases its centers to KLC OpCo for an aggregate annual rent of $96.3 million. The lease agreement, which was signed in November 2005, carries an initial term of 15 years with two extensions available for five years each and an escalation of rent by the lesser of 7% or the CPI every fifth year. All of the properties have been leased to KLC OpCo on a "triple-net" basis, requiring KLC OpCo to fund all property taxes, insurance expenses related to the properties and all maintenance capital expenditures. For the fiscal year ended December 31, 2005, KLC PropCo generated pro forma rental revenue of $96.3 million and EBITDA of $88.1 million. 12.1. KLC PropCo Strategy KLC PropCo was separated from KLC OpCo to create a flexible vehicle to address the growing opportunity in education related real estate. The ongoing need for facility-based education is driving increased demand for real estate assets that can accommodate the facilities. 3° Actual appraisal was for 713 centers and the appraised value was $1.1 billion. The $1.25 billion referred to within this Memorandum is achieved by taking the independent appraisal valuation methodology and extrapolating it to the remaining 132 centers. 100 • Leverage Greenstreet Real Estate Partners' significant expertise: — KLC believes it is able to better maximize the potential of its real estate assets by having them managed by a dedicated and highly experienced team at Greenstreet Real Estate Partners rather than having them managed at the operating company level. • Cash generated will be reinvested in acquiring more assets. • Diversify the real estate portfolio: — The Greenstreet Real Estate Partners team is actively looking at diversification and reinvestment opportunities for the real estate portfolio. The diversification strategy will include some opportunistic investments in non-education related real estate assets. 12.2. Management Team KLC PropCo is managed by Greenstreet Real Estate Partners through a long-term agreement. Greenstreet Real Estate Partners has a highly experienced management team to guide the continued acquisition and diversification of the real estate portfolio. The management team includes Steven Green, Chairman and CEO of Greenstreet Real Estate Partners, Jeffrey Safchik, COO and CFO and Steven Cox, Executive Vice President Real Estate. Greenstreet Real Estate Partners controls a significant portfolio of owned and self-managed real estate and has extensive experience in corporate transactions involving owned real estate. Greenstreet Real Estate Partners operates a private real estate equity platform, having made in excess of $850 million in acquisitions and with assets currently under management (excluding KLC PropCo) of $540 million. It has owned and managed in excess of 10 million square feet of shopping centers with value in excess of $1 billion. The principals of Greenstreet Real Estate Partners each have in excess of 20 years in real estate and capital markets. Their biographies can be found in Appendix A. 12.3. Description of the Real Estate Assets The highly diversified portfolio includes 845 properties in 37 states. The properties are primarily one story wood-framed buildings totaling 5,119,320 sq. ft. Some of the larger state concentrations include Texas, California, Illinois and Virginia. No single state accounts for more than 11% of the total centers (see the Figure below for details on the geographic distribution). The properties are single-tenant stand-alone buildings. The average age of the properties is approximately 15 years with 22% of the portfolio built after 1991 and approximately 6% of the facilities being constructed prior to 1979. The centers' trailing 12 month Utilization was 58.9% as of December 31, 2005. 101 845 Centers in 37 States 12.4. Summary Financial Information and Projections Discussion The table below shows KLC PropCo pro forma historical results for 2005 assuming the division of KLC OpCo and KLC PropCo in the series of transactions completed in November 2005 (the "Real Estate Transactions") and related financing, together with the lease of KLC PropCo-owned centers to KLC OpCo, occurred on January 1, 2004. Projected results presented below are based on assumptions management believes to be reasonable, but which are inherently uncertain and may not be realized. KLC PropCo's ability to perform as projected depends on a number of variables that cannot be predicted with certainty and actual performance could be adversely affected by a number of factors, including those described in "Risk Factors," particularly the risk factor related to projected financial statements, elsewhere in this Memorandum. Also see "Forward Looking Statements." 102 KLC PropCo Summary Historical Pro Forma and Projected Financials Fiscal Year Ended December 31, ($ in millions) 2005 PF 2006P 2007P 2008P 2009P 2010P 2011P Rental Revenue from KLC OpCo $96.3 $96.3 $96.3 $96.3 $96.3 $96.3 $103.0 Other Rental Revenue' 0.0 0.0 4.6 7.0 9.4 12.1 15.0 Total Revenue $96.3 $96.3 $100.9 $103.3 $105.7 $108.4 $118.0 Operating Expenses 8.3 8.3 8.3 8.3 8.3 8.3 8.3 EBITDA $88.1 $88.1 $92.6 $95.0 $97.4 $100.1 $109.8 DEPRECIATION & AMORTIZATION Depreciation $29.8 $27.0 $26.1 $25.0 $23.8 $22.4 $22.4 Depreciation From New Real Estate 0.0 0.0 2.8 4.2 5.7 7.3 9.1 Operating Income $58.6 $61.1 $63.7 $65.8 $68.0 $70.4 $78.3 INTEREST EXPENSE KLC PropCo Debt $64.3 $64.3 $63.9 $63.5 $63.2 $62.8 $62.5 Deferred Financing Fees 2.1 2.1 2.1 2.1 2.1 2.1 2.1 Total Interest Expense $66.4 $66.3 $66.0 $65.6 $65.2 $64.9 $64.5 Interest Income 1.1 1.1 0.2 0.2 0.2 0.2 0.2 Net Income ($7.0) ($4.2) ($2.0) $0.4 $2.9 $5.8 $14.0 BALANCE SHEET DATA Cash and Equivalents $24.5 $5.0 $5.0 $5.0 $5.0 $5.0 $5.0 Total Debt2 849.4 844.7 839.9 835.3 830.6 826.0 815.8 Net PP&E 687.1 715.6 715.5 715.8 718.6 724.5 740.3 SELECTED CASH FLOW DATA Net Income (Loss) to Common ($7.0) ($4.2) ($2.0) $0.4 $2.9 $5.8 $14.0 + Depreciation 29.8 27.0 26.1 25.0 23.8 22.4 22.4 + Real Estate Reinvestment Depreciation 0.0 0.0 2.8 4.2 5.7 7.3 9.1 + Amortization of Financing Fees 2.1 2.1 2.1 2.1 2.1 2.1 2.1 + Non-Cash Interest Expense 2.3 2.3 2.3 2.3 2.4 2.4 2.4 + Change in Working Capital NA 0.0 0.6 0.3 0.3 0.3 1.2 + Change in Other Assets Held for Sale NA 15.8 0.0 0.0 0.0 0.0 0.0 + Change in Other Assets NA 0.0 (0.7) (0.4) (0.4) (0.4) (1.5) + Change in Other Liabilities NA 0.0 4.8 2.5 2.5 2.8 10.1 = Operating Cash Flow $27.1 $43.0 $35.9 $36.4 $39.3 $42.6 $59.8 Cash Reinvested in New Real Estate' $0.0 $55.5 $28.9 $29.4 $32.3 $35.6 $47.2 'Assumes reinvestment of all excess cash above $5.0 million at an 8.25% cap rate. 2 Junior Mezzanine debt is recorded at face value. Book value is approximately $147.3 million. Rental Revenue Management projects rental revenue to increase at a 4.2% CAGR, from $96.3 million (the annual rent payable pursuant to its leases with KLC OpCo) in 2006 to $118.0 million in 2011. The growth stems from KLC PropCo's reinvestment of excess cash flow in additional real estate and rent increases in the properties leased to KLC OpCo as described below: Intercompany Rent. KLC PropCo currently leases 847 properties (845 childcare centers) to KLC for a total annual rent payment of $96.3 million. The rent on the properties is fixed for the first five years of the lease, at which point it increases by the lesser of the CPI growth over the five years or 7%. Additional Real Estate. KLC PropCo has projected that it will invest all excess cash (anything over $5.0 million) in additional real estate. The additional real estate may be comprised of either educational or non-educational assets, but will not be leased back to KLC OpCo. KLC PropCo has projected that it will invest its capital at an 8.25% cap rate. 103 Real Estate Company Operating Expenses Greenstreet Real Estate Partners will operate all of the real estate investment functions on behalf of KLC PropCo as detailed in the management agreement. See "Related Party Transactions." 12.5. Debt Summary The table below shows KLC PropCo's outstanding capitalization as of December 31, 2005. KLC PropCo Debt Capitalization ($ in millions) 12/31/05 Cash $ 24.5 CMBS Debt $699.4 Junior Mezzanine Debt' 150.0 Total KLC PropCo Debt $849.4 Net Debt2 $824.9 1 Represents face value; book value is approximately $147.3 million. 2 Represents total debt less cash. 12.6. Terms of the CMBS Debt KLC PropCo has $699.4 million of CMBS debt which was arranged in connection with the separation from KLC OpCo. KLC PropCo is required to pay interest in cash on a monthly basis at a rate of 5.62% and must meet scheduled amortization requirements on a monthly basis and maturing December 1,2015. The CMBS debt consists of a $649.5 million mortgage loan and a $50.0 million senior mezzanine loan secured by 713 childhood education centers. The CMBS debt is nonrecourse KLC OpCo. Each of the centers securing the mortgage loan is leased to KLC OpCo pursuant to a master lease. KLC PropCo has entered into asset management agreements with Greenstreet Real Estate Partners (formerly Greenstreet Realty Partners, L.P.) pursuant to which Greenstreet Real Estate Partners provides asset management and consulting services for these centers to KLC PropCo. KLC PropCo has the right under certain circumstances to release, substitute, sell and/or reinvest in properties securing the mortgage loan. Prepayment of the CMBS debt is prohibited through January 1, 2007, after which prepayment is permitted in whole or in part, subject to a prepayment premium equal to the greater of 1% or an amount obtained based on a discount to treasury securities. After June 1, 2015, the CMBS debt may be prepaid in whole without premium or penalty. The CMBS debt contains provisions that require KLC PropCo to reserve with the lender of the CMBS debt 50% of excess cash flow generated from the CMBS centers if EBITDA (as adjusted) for KLC OpCo falls below certain levels and 100% if EBITDA (as adjusted) for KLC OpCo falls below certain other levels. 12.7. Terms of the Junior Mezzanine Debt The Junior Mezzanine debt has a face value of $150 million (and was purchased for approximately $147.0 million, reflecting a 2% discount to face value), substantially all of which was provided by the 104 Principals and their affiliates in connection with the Real Estate Transaction. The Junior Mezzanine debt is subordinated to the new CMBS debt. Cash interest is payable on the Junior Mezzanine debt at a rate of 15.13% and payable in kind at a rate of 1.50%. The Junior Mezzanine debt matures in May of 2016. Interest paid in kind may not be paid in cash until the CMBS debt is paid in full. The Junior Mezzanine debt is nonrecourse to KLC OpCo. Prepayment of the Junior Mezzanine debt is prohibited through November 9, 2010, after which prepayment is permitted in whole or in part, subject to a prepayment premium equal to 8.32% for prepayments in the first year, 6.66% for prepayments made in the second year, 4.99% for prepayments made in the third year, 3.33% for prepayments made in the fourth year and 1.66% for prepayments made in the fifth year. After November 9, 2015, the CMBS debt may be prepaid in whole without premium or penalty. 12.8. Terms of the Master Lease As part of the Real Estate Transactions, in November 2005, KLC refinanced its indebtedness and divided KUE into KLC OpCo and KLC PropCo, and KLC OpCo entered into a Master Lease with KLC PropCo for 713 centers. The term of the Master Lease is 15 years and annual rent under the Master Lease is $91 million per year, subject to increases every five years. The Master Lease is a triple net lease that requires KLC OpCo to pay all operational expenses, taxes, utilities, insurance and maintenance costs with respect to the leased centers, and the Master Lease may not be terminated by KLC OpCo. KLC OpCo is required to make certain deposits or to provide letters of credit for taxes, insurance and maintenance of the properties. KLC is also required to deposit rent payments into a segregated deposit account controlled by the CMBS debt lenders. KLC OpCo has the right under certain circumstances to release and substitute properties under the Master Lease. KLC OpCo has entered into separate, substantially smaller leases of KLC PropCo's remaining properties. 105 13. k12 INC. ("k12") k12, headquartered in McLean, Virginia, is a curriculum company and management company for kindergarten through ninth grade (grades 10-12 currently in development). k12 is the largest operator of K-12 virtual schools in the world. k12's mission is to enable delivery of world-class education for students in grades K-12, consisting of comprehensive online and offline curriculum that supports numerous applications. k12 has invested more than $70 million in building a state-of-the-art curriculum offering, integrated assessment and the supporting technology delivery systems. 13.1. History k12 was founded in December 1999, with the goal of leveraging technology to create the highest-quality curriculum. k12 launched its first offering in September 2001 for students in grades K-2. This offering was launched in conjunction with several of the world's leading education experts and included interactive lessons in Language Arts, Math, Science, History, Art and Music. k12 launched grades 3-5 in the fall of 2002, grades 6 and 7 in the fall of 2003, grade 8 in the fall of 2004 and grade 9 in fall of 2005. k12 has continually improved its production process and is now producing courses that are of higher quality and at a lower cost per lesson than it originally produced. Building the service in this modular, rolling fashion allows k12 to capture students at an early stage and to build out its product offerings in alignment with student progress. 13.2. Current Operations k12 provides a world-class education for its students which combines a comprehensive online and offline curriculum with integrated assessments and supporting technology delivery systems. k12 currently provides its education to grades K-9 through more than 7,000 interactive lessons, and is in the process of developing content for grades 10-12. Today, k12 sells its curriculum through the following channels: • Virtual public schools (91% of 2006E Revenue) — k12 is the largest curriculum and management provider to virtual public schools in the U.S. — k12 offers its curriculum directly to the rapidly growing virtual school market (projected to be offered to 24,000 students in 2007) • District-managed virtual programs (3% of 2006E Revenue) — k12 sells the curriculum and technology directly to school districts who mange their own virtual schools — This is a fairly new initiative for k12 but is expected to be a larger part of total revenue over time • School districts for traditional classrooms (3% of 2006E Revenue) — k12's science curriculum has been piloted as the science curriculum in various school districts including Philadelphia — Initial results are promising • Direct to consumer (3% of 2006E Revenue) — To parents who prefer home-schooling or want to augment or enhance their children's public or private school education 106 k12 intends to expand the business to international markets and believes there is a significant worldwide demand for high-quality online curriculum. In the near-term it can do so by serving multinational corporations with large employee bases comprised of expatriates. k12 generated $6 million of revenue in 2002, its first year of operations, growing to more than $116.0 million projected for FYE June 30, 2006. 13.3. Virtual Schools and District-Managed Virtual Programs (94% 2006E Revenue) The past decade has seen an increase in the number of contracts and charters awarded to Education Management Organizations ("EMOs"), which manage traditional K-12 public schools on behalf of a school district ("contract schools") or manage charter schools either as the charter holder ("charter schools") or under contract with the charter holder ("contract charters"). In the early half of the 1990's, EMOs were mostly contract schools, managing traditional K-12 schools on behalf of school districts. Later, as public money became available to charter schools through the use of vouchers, these organizations moved toward charter school management and contract charter management. A movement toward alternatives to the public school system is expected to generate substantial growth in the for-profit EMO sector. Alternative schools and alternative management programs provide a significant opportunity to improve the current educational "product." Furthermore, under the NCLB, growth in public school management is expected to continue as schools that fail to achieve "Adequate Yearly Progress" ("AYP") for four consecutive years are subject to one of the following sanctions: replacement of all or most staff including the principal, state takeover of the school, hiring an outside entity to manage the school, or becoming a charter school. k12 is well positioned to take advantage of these trends. To comply with NCLB, all states submitted a plan to the Department of Education indicating baseline achievements for the 2002-03 school year and how 100% "proficiency" would be achieved by 2013-14. The law mandates that student progress and achievement be measured ("assessed") by math and reading tests that will be given to every child, every year, beginning in the 2005-06 school year. In addition, a science assessment will be added beginning with the 2006-07 school year. Under Bush administration proposals, by the 2009-10 school year, students will be tested every year from grades 3 to 11. These assessments are considered intermediate benchmarks that measure a school's ability to demonstrate "Adequate Yearly Progress" (AYP) toward meeting its own goals. Contract Charters. Charter schools are independent public schools, designed and operated by community groups or non-profit entities, but sponsored by designated local or state educational organizations that monitor their quality and integrity. In return for a large measure of autonomy and freedom from regulation, charter schools are accountable for student academic performance. The Center for Education Reform estimates that, in the 2004-05 school year, there were 3,345 charter schools serving nearly 894,000 students, representing an estimated 1.6% of total K-12 students. Charter schools now operate in 40 states and the District of Columbia, up from 38 in the 2003-04 school year. In the 2004-05 school year, enrollment in charter schools represented 1.6% of total K-12 enrollment and annual spending on charter schools was $7 million or 1.4% of total spending on all K-12 schools. However, in the decade of 1995-2005 the number of charter schools had grown on average nearly 13% annually while charter school enrollment increased over 20%, clearly outpacing the less than 1% average K-12 enrollment growth over the same period.37 k12 participates in the charter school business by setting up virtual public schools that it manages through a partnership with a non-profit entity. After going through the legislative process at the local or state level and obtaining a charter for a school, k12 sets up a non-profit organization with a principal and the right administrative team to create the school. k12 then enters into a contract with the non-profit organization '7 Source: Harris Nesbitt, Education and Training, September 2005. 107 whereby k12 sets up and manages the "virtual public" school. k12 offers an Internet-based curriculum (providing the computer hardware and all necessary materials) outside of the conventional brick-and- mortar setting of traditional public and charter schools. Where legislation has enabled such schools, state education dollars pay for children who enroll in them. Virtual schools generally generate substantially larger profits than conventional for-profit charter schools because they receive the same amount of per- student funding as their traditional public school counterparts despite not having to support a physical structure. Virtual schools enable students to receive a comprehensive curriculum along with technical assistance, teacher involvement, computer equipment, Internet access, and instructional materials, without leaving the public education system. Virtual academies are serving a diverse mix of students. With the same curriculum, k12 is serving both highly gifted children and children with disabilities. The self-paced nature of k12's curriculum and its interactivity allow k12 to serve a broad array of students. k12's students, currently in virtual schools, come from public or private schooling backgrounds, as well as home schooling backgrounds. A summary of k12's virtual school business is as follows: • k12 manages virtual schools for students in grades K-9 in 11 states (Arizona, Arkansas, California, Colorado, Florida, Idaho, Minnesota, Ohio, Pennsylvania, Texas and Wisconsin) plus the District of Columbia. In the 2006 fiscal year, these schools had a combined enrollment of approximately 18,000 children. • k12 managed schools typically produce test score results which exceed or are equal to state averages at a cost to the taxpayer that is approximately 70% less than what they would pay for traditional school. • Virtual schools are funded primarily through local, state, and federal sources, which k12 expects to receive approximately $5,300 per student per school year on average. Therefore, the virtual schools provide access to k12's world-class service and curriculum as well as certified teachers at no cost to the family. • While many of k12's virtual academies are charter schools, k12 has virtual schools that are not charter schools but are programs of school districts or other authorized school agencies, such as public universities and federal and state agencies. District-Managed Schools. k12's district-managed virtual programs operate under the contract schools model. Although somewhat similar to the virtual public schools, contract schools are public schools operated by private organizations based on management agreements with local school boards. Unlike charter schools, contract schools do not require specific statutory authority but are created through a contract between a school management company and a school board in accordance with existing authority. k12 typically employs the district-managed virtual programs in states where the reimbursement rate is low. Two states where k12 currently has district-managed virtual programs are Kansas and Utah. The district-managed virtual programs unit is expected to grow revenue from $3 million in FY 2006 to $11 million in FY 2008. The Pennsylvania Department of Education commissioned KPMG Consulting to study virtual education in that state. The October 2001 study stated that the Pennsylvania Virtual Charter School (which uses the k12 curriculum and management services) 'Was considered to be the highest quality program based on the curriculum analysis." k12 believes that the virtual school market has powerful growth prospects which are outlined below: ^ Strong reenrollment rates. k12 benefits from stable demand for its curriculum and services which is reflected by current reenrollment rates of approximately 70%. ^ Increasing existing school enrollment rates. Existing school enrollments continue to increase at double digit rates. ^ Expansion into new states. k12 is currently evaluating opportunities to start new virtual schools in several additional states. 103 • Grade expansion. k12 continues to expand its curriculum and services and plans to begin development of grades 10-12 in the fall of 2006. • ADA funding. The level of funding generally increases at approximately 2% per year. With four times the number of students of its next competitor, k12 is the largest for-profit manager of virtual schools. Virtual Schools Managed by For-Profit Educational Management Companies Company k12 White Hat Management Connections Academy Pinnacle Education Sequoia Charter Schools Designs for Learning Location McLean, VA Akron, OH Baltimore, MD Tempe, AZ Mesa, AZ St. Paul, MN Public Schifolninder Management Number of which are Students in Virtual Virtual Schools 15 15 38 2 10 10 9 1 11 1 10 1 Note: Schools ranked by students in 2004-05 school-year. Source: Harris Nesbitt based on information compiled by Education Policy Studies Research Unit at Arizona State University. Schools 14,460 3,508 1,081 212 160 50 13.4. Curriculum to School Districts of Traditional Classrooms (3% 2006E Revenue) k12 piloted its core elementary school science program for several school districts, including Philadelphia. The initial results of this pilot program were promising. Case Study: William H. Hunter Elementary School Background. In the Spring of 2004 the School District of Philadelphia wished to give a rebirth to one of its lowest performing schools, the William H. Hunter Elementary School. k12 was selected as a partner to provide innovative curriculum and professional development to implement a learning environment that leverages the latest technology. As part of the k12 implementation, the District outfitted each room with high-speed internet access, a ceiling-mounted data projection system, and interactive whiteboards. The goal was to have Hunter become one of the District's, and the Commonwealth of Pennsylvania's, first web-based public, traditional schools. Of Hunter's 600 students, 95% qualify for the federal Free and Reduced Lunch program and 25% study English as a Second Language (ESL). Therefore, the move and the District's initiative truly marked a tremendous opportunity for both Hunter's teachers and students alike. Scope of Services. The fall of 2004 marked the official launch of the program and the k12 curriculum was provided for all math, science, art and history courses. This included providing all curriculum components including text books, teacher guides, manipulatives, equipment, assessments, art supplies and all the online lessons and teaching tools for these subjects. The Hunter teaching staff did an impressive job of effectively implementing the program. k12 trainers worked closely with teachers to adopt the new curriculum and to share best methods on applying the technology. Throughout the year, k12 trainers were invited to attend and help present ongoing staff trainings. Additionally, grade level teams and school leaders worked regularly with k12 to develop coherent plans for boosting student achievement. Results / Conclusions: After the first full-year of implementing the k12 program, Hunter achieved impressive gains on the state math exams.38 In third grade, there was a 46 percentage point increase (as 38 The Pennsylvania Department of Education mandates all public schools in the Commonwealth implement its Pennsylvania System of State Assessment (PSSA). The PSSA is a standards-based exam for measuring specific skills in math and reading, and beginning in 2006-07 science. 109 compared to a 31 point increase for the District). This was a meaningful 86% performing at or above proficient compared to the District's 52% for 2005. In fifth grade, there was 22 percentage point gain (as compared to a 15 point gain for the District). As a result of these scores, the 3rd and 5th grade students met or exceeded the absolute AYP goals for math instruction - a first for the school. (Note: k12 did not supply the Reading curriculum, therefore, only Math results are applicable to the k12 program). These gains are an extraordinary achievement for a school and its district. They are also difficult to maintain over time, however this goal is shared between the District and k12. The Hunter School accomplished these gains through the staff's hard work, commitment to their students and dedication to implementing the k12 program. Year over Year PSSA Math Gains (2004 to 2005 % point increase) Third Grade Hunter District Fifth Grade Hunter District 22 31 46 New programs often take two to three years to generate similar results. While k12 and the Hunter staff are pleased with the first year's results, it is only the beginning of a longer effort because, despite the gains, more than half of last year's fifth graders still did not score at or above their grade level. Therefore, although there is pride in the progress, the overall scores demonstrate how much more is to be done. 13.5. Direct to Consumer (3% of 2006E Revenue) k12 sells its curriculum direct to consumers who either home school their children or use k12's curriculum to supplement their child's education. k12 believes that it offers children and their parents an education comparable to that offered in the nation's best public and private schools, utilizing optimal multimedia methods and research-tested approaches to learning. In addition, integrated assessments allow a parent to test his or her child's mastery of skills and enables the child to progress at the appropriate pace. Children can move faster through lessons and address more challenging problems, while other children can spend the additional time needed to master certain skills. With k12 's high standards and integrated assessments, a parent can be confident that his or her child has mastered the subject. k12 considers this market a growth area. Educating a child at home full time or part time is a time-consuming and daunting task for parents. Parents and caregivers spend a considerable amount of time searching for curriculum and trying to ensure they are teaching the material adequately to their children. k12 offers a solution to this challenge by offering a comprehensive curriculum for students in grades K-9, complete with specific daily lessons. Parents can purchase individual or multiple courses. Although small, the home-schooling market is growing at a healthy pace. Approximately 1.1 million students—roughly 2% of total K-12 enrollment— were home-schooled in spring 2003, according to the National Center for Education Statistics (NCES). This represents a roughly 30% increase from spring 1999. Most home school parents cited concerns about the school environment (31%), interest in providing religious instruction (30%) and overall dissatisfaction with academic instruction (16%) as their reasons for home schooling their children.39 The exam is also used in assessing performance toward No Child Left Behind guidelines for grades 3, 5, 9 and 11. The goal of the exam is for students to score at or above proficient levels. Student results are also used to determine a school and district's performance in meeting pre- determined goals known as Adequate Yearly Progress (AYP). 39 Source: Harris Nesbitt, Education and Training, September 2005. 110 13.6. Product Offering Comprehensive K-9 Curriculum. k12 offers a comprehensive curriculum for grades K-9 directly to the students in its virtual academies, directly to consumers and to school districts, summer schools and after- school programs. k12 is creating rich and challenging proprietary educational material based on existing best-of-breed content and traditional methods enhanced by technology. Unlike most computer-based education programs, which rely solely on computers and burden students with mechanical 'point and click" exercises, k12 uses the computer as only one among many complementary tools to open children's minds to the best books and educational material. k12's math, reading and writing curriculum involve a significant amount of off-line work in the form of books, audiotapes, science equipment, art supplies and more. k12 provides some of these materials and others will be recommended but not required. For example, k12's comprehensive curriculum for students in grades K-9 includes lessons in the following subjects: • Language Arts. Progresses from a focus in the primary grades on early mastery of reading using phonics-based curriculum reviewed and revised by a team of renowned experts, to, in later grades, a rich program of literature, composition, and language skills; • Math. A solid early foundation in basic math based on a highly respected math curriculum and rigorous math standards; • History. In grades K-4, a proprietary k12 program that offers a chronological overview of history, from the Stone Age to the Space Age, with integrated geography and civics; in middle school, an American History survey based on the celebrated History of the US series, and a World History survey based on a proprietary k12 textbook; • Science. A world-class science curriculum focused on hand-on activities and basic principles driven by some of the most ambitious state science standards in the country; • Visual Arts. A curriculum that combines appreciation of historical trends and masterpieces with specific skill building and many opportunities for creative work; and • Music. In the elementary grades, a proprietary program that engages young children in singing, dancing and creative movement while introducing them to great works of music from around the world. k12's curriculum and assessment are delivered, in part, through a series of proprietary course modules. k12 delivers material over the Internet, but also through other forms of media, including traditional books, video and learning kits. k12's course modules employ interactive text, audio, videos, CDs, and animated graphics. The Internet-based portion of k12's courses contains the following features: • Integration of a diverse mix of materials—visual images and concepts, audio, videos and animated sequences, as well as high-quality written material; • Capabilities for users to see an overview of the whole module at a glance; • Opportunity for parents to scan and preview modules before guiding students through work; • Integrated assessment services; • Ability for children, parents, and teachers to follow students' progress; • Comprehensive teaching guides with "drill down" functionality for those parents requiring more detailed instruction; and • Proven, standards-based, technologies that provide a satisfactory experience for the current Internet infrastructure. 111 k12 considers the majority of its entire curriculum proprietary, whether k12 is branding existing materials with its logo and modifying the associated lesson plans or creating the entire course from scratch. k12's K-8 curriculum includes thousands of lessons that consist primarily of existing, high-quality materials that k12 has modified to better suit the needs of student, parent and teacher. 13.7. Management and Board of Directors The following table sets forth certain information regarding k12's management and directors. For more detailed biographical information, see Appendix A. Management Name Ron Packard John Baule Bror Saxberg Thomas Boysen Charles Zogby Peter Stewart Bryan Flood John Holdren Name Arthur Bilger Steven B. Fink Chester Finn Lowell J. Milken Andrew H. Tisch Thomas Wilford Liza Boyd Position Chairman and Founder / acting Chief Executive Officer and member of the Board of Directors Executive Vice President and Chief Financial Officer Senior Vice President of Learning and Content Senior Vice President and Chief School Officer Senior Vice President of Education Policy Vice President of the Charter School Division Vice President of Government Relations Senior Vice President of Curriculum Non-Employee Directors Position Managing Member of Shelter Capital Partners Chief Executive Officer of Lawrence Investments, LLC President of the Thomas B. Fordham Foundation President and Chief Executive Officer of KUE Chairman of Executive Committee of Loews Corporation Chief Executive Officer of the J.A. and Kathryn Albertson Foundation, Inc. Vice President Constellation Ventures / Bear Stearns Asset Management 13.8. Summary Financial Information and Projections Discussion The following summary historical financial data and the percentages of expected 2006 revenue presented in the headings above are based on historical financial statements. The following projected financial data presented below is based on assumptions management believes to be reasonable, but which are inherently uncertain and may not be realized. k12's ability to perform as projected depends on a number of variables that cannot be predicted with certainty and actual performance could be adversely affected by a number of factors, including those described in "Risk Factors," particularly the risk factor related to projections elsewhere in this Memorandum. Also see "Forward-Looking Statements." 112 k12 Summary Historical and Projected Financial Information Fiscal Year Ended June 30, ($ in millions) 2002 2003 2004 2005 2006P 2007P Revenue $6.7 $30.9 $71.4 $85.3 $116.0 $132.2 Growth 362.1% 131.0% 19.5% 36.0% 14.0% Operating Income ($30.4) ($28.0) ($6.9) ($3.3) $2.0 $6.4 Operating Income (454.3)% (90.4)% (9.7)% (3.8)% 1.7% 4.8% Margin EBITDA ($28.6) ($25.1) ($2.0) $2.2 $5.7 $12.3 EBITDA Margin (427.9)% (81.1)% (2.8)% 2.6% 4.9% 9.3% Net Income ($30.4) ($28.4) ($7.4) ($3.5) $1.3 $5.2 Net Margin (454.5)% (91.7)% (10.4)% (4.1)% 1.1% 3.9% Historically, the majority of k12's revenue has been from virtual schools and district-managed virtual programs. Traditionally, k12's revenue growth has been driven by three major factors; (i) the addition of grades, (ii) the addition of states and (iii) same-store growth in existing states. In 2002 k12 began operations in two states (Colorado and Pennsylvania). In 2003 revenue grew to $30.9 million from $6.7 million during the 2002 fiscal year end. Growth was due to the addition of four new states (Ohio, Idaho, California and Arkansas), three new grades and same store sales growth of approximately 40%. During 2004 revenue increased by 131.0% to $71.4 million. Revenue growth during the 2004 fiscal year was due to the addition of five new states (Minnesota, Arizona, Florida, Wisconsin and the District of Columbia) and two new grades. During the 2005 fiscal year k12 began to concentrate on leveraging its scale to achieve profitability by slowing down curriculum production and not aggressively pursuing new states. Revenue grew at a slower rate, but profitability increased as the growth in the existing states continued. Existing state growth is more profitable than new state growth because each new state requires a significant amount of fixed overhead to be added. The projections of financial results presented above are based on the development and expansion of k12's operations in existing states and grades. Key growth drivers in the near term are expected to include high same-store growth rates and k12's ability to leverage its existing infrastructure for margin improvement. Future drivers of growth at k12 which are not included in the projections are expected to include the addition of new states. In 2006, k12 opened in Texas, Wyoming and Washington. More recently, the Chicago school board approved a virtual public school for the city of Chicago that will be managed by k12. k12 also received a charter in the Sacramento area of California that will allow it to serve a large area in California that it cannot currently serve. k12 is currently continuing to pursue opportunities in several other states. Under k12's current revenue recognition policy, revenues are principally earned from contractual agreements to provide on-line curriculum, books, materials, computers and to manage and operate virtual charter schools. In most contracts, k12 is responsible to the charter schools for all aspects of the management of schools, including but not limited to the monitoring of the academic achievement of the students, training, and compensation of school personnel; and procurement of curriculum and equipment necessary for operations of the schools. The schools receive funding on a per student basis from the state in which the charter school or school district is located. Where k12 has determined that they are the primary obligor for substantially all expenses under these contracts, k12 records the associated per student revenue received by the school from its state funding school district up to the expenses incurred in accordance with Emerging Issues Task Force (EITF) 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent. k12 has generally agreed to fund any operating losses of the schools in a given school year; however, k12 is not entitled to any revenue in excess of expenses incurred on its contracts, 113 unless k12 incurred excess losses in prior years. For contracts in which k12 is not the primary obligor, k12 records revenue based on its net fees earned per the contractual agreement. Under k12's current revenue recognition policy, k12 records revenue related to contracts with its virtual academies primarily on a gross basis. As a result, k12 has recorded certain expenses of these virtual academies in revenues and costs and expenses. These expenses were $25.4 million and $29.3 million for the fiscal years ended June 30, 2004 and 2005 respectively. 13.9. k12 Equity k12 has issued and outstanding approximately 45.1 million shares of Series C Preferred Stock, approximately 51.5 million shares of Series B Preferred Stock and approximately 10.0 million shares of Common Stock. The Series C Preferred Stock is senior to the Series B Preferred Stock and the Common Stock and has a liquidation preference equal to the greater of (a) two times the original cost of the Series C Preferred Stock (plus any accrued dividends) or (b) the amount which would be received upon conversion of the Series C Preferred Stock into Common Stock. KUE owns approximately 40.0% of the outstanding Series C Preferred Stock. The Series C Preferred Stock has a dividend rate of 10% per annum, compounded annually with such dividends being paid in the form of additional shares of Series C Preferred Stock. The Series B Preferred Stock is senior to the Common Stock and has a liquidation preference equal to the greater of (a) two times the original cost of the Series B Preferred Stock or (b) the amount which would be received upon conversion of the Series B Preferred Stock into Common Stock. KUE owns approximately 7.5% of the outstanding Series B Preferred Stock. The holders of the Series B Preferred Stock do not receive dividends. KUE does not own any shares of Common Stock. However, both the Series B Preferred Stock and the Series C Preferred Stock are convertible into k12 Common Stock, and on an as-if-converted, fully-diluted basis KUE owns approximately 17.9% of k12's Common Stock. 114 14. THE STRUCTURE OF KUE AND THE GENERAL PARTNER The following information is a summary of the principal terms of the organizational documents of KUE and the General Partner. The information below is qualified in its entirety by reference to the Amended and Restated Limited Partnership Agreement of KUE and the organizational documents of the General Partner, including the Amended and Restated Memorandum and Articles of Association of the General Partner and the Agreement Among Members of the General Partner (the "Organizational Documents), copies of which have been provided or are available upon request In the event of any inconsistency between the terms herein and the terms of the Organizational Documents, the Organizational Documents shall control. 14.1. KUE KUE is constituted as a Cayman Islands exempted limited partnership under the Exempted Limited Partnership Law (2003 Revision) (the "ELP Law"). A Cayman Islands exempted limited partnership is constituted by the signing of the relevant partnership agreement and its registration with the Registrar of Exempted Limited Partnerships in the Cayman Islands. Notwithstanding registration, an exempted limited partnership is not a separate legal person distinct from its partners. Under Cayman Islands law, any property of the exempted limited partnership shall be held or deemed to be held by the general partner, and if more than one then by the general partners jointly upon trust, as an asset of the partnership in accordance with the terms of the partnership agreement. Similarly, the general partner for and on behalf of the partnership incurs the debts or obligations of the exempted limited partnership. Registration under the ELP Law entails that the partnership becomes subject to, and the limited partners therein are afforded the limited liability and other benefits of the ELP Law. The business of an exempted limited partnership will be conducted by its general partner(s) who will be liable for all debts and obligations of the exempted limited partnership to the extent the partnership has insufficient assets. As a general matter, a limited partner of an exempted limited partnership will not be liable for the debts and obligations of the exempted limited partnership save (i) as expressed in the partnership agreement, 00 if such limited partner becomes involved in the conduct of the partnership's business or (Hi) if such limited partner is obliged pursuant to Section 14(1) of the ELP Law to return a distribution made to it where the exempted limited partnership is insolvent. The Limited Partnership Agreement of KUE limits the liability and reduces the fiduciary duties of the General Partner to the Limited Partners of KUE (the "Limited Partners," and, together with the General Partner, the "Partners") to the full extent of applicable law. The Limited Partnership Agreement also restricts the remedies available to the Limited Partners for actions that might otherwise constitute a breach of the General Partner's fiduciary duties owed to the Limited Partners. By purchasing Units, Investors are treated as having consented to various actions contemplated in the Limited Partnership Agreement and conflicts of interest that might otherwise be considered a breach of fiduciary or other duties under applicable Cayman law. 14.2. The General Partner The General Partner is incorporated in the Cayman Islands as an exempted company with limited liability under the Companies Law (2004 Revision) (the "Companies Law"). The Memorandum and Articles of Association comprise the constitution of General Partner. The principal business purpose of the General Partner is to act as the general partner of KUE, to own interests in KUE and to engage in activities related thereto (the "Business Purpose"). The General Partner will not engage in material activities (including holding any material assets or incurring any material liabilities) unrelated to the Business Purpose. The General Partner has no prior operating history or prior business and will not have any substantial assets or 115 liabilities other than in connection with its acting as general partner of KUE and as described in this Memorandum. The day to day business of the General Partner will be generally be conducted by its directors, although certain matters require the approval of its shareholders pursuant to the Companies Law and the General Partner's Articles of Association. Under Cayman Islands law, a director of a Cayman Islands company is obliged to comply with a number of duties, breach of which may, in certain circumstances, result in personal liability on the part of the director. However, provided a director complies with the fiduciary duties and the requisite duties of care, diligence and skill, the fact that a decision turns out to be wrong, not beneficial, or causes loss, will not of itself necessarily establish personal liability. As a general rule, in the absence of a contractual arrangement to the contrary, the liability of a shareholder of a Cayman Islands exempted company which has been incorporated with limited liability is limited to the amount from time to time unpaid in respect of the par value of, together with the share premium payable on, the shares he holds; the company having a separate legal personality from that of its shareholders, and being separately liable for its own debts due to third parties. However, although there is no decided Cayman Islands authority on the issue, English common law authority (which would be regarded as persuasive, though technically not binding, in the courts of the Cayman Islands), supports the proposition that it in exceptional circumstances it is conceivable that the principle of the separate legal personality of a company could be ignored and the court will "pierce the corporate veil." Examples might be a company acting as the agent or nominee of its shareholder, incorporation for an illegal or improper purpose, using a company or group of companies as a means of perpetrating a fraud, or using the separate personality of a company to circumvent a pre-existing obligation of its proprietor. 14.3. Classes of Units; Capital Contributions Assuming that 1,000,000 Units are sold to Investors by March 31, 2007, and that the accrued dividends on the preferred limited partner units are paid in cash, approximately 2,530,000 Units will be outstanding. The Investors will own approximately 40% of KUE in the form of Common LP Units and approximately 40% of the General Partner in the form of Class A Shares. The General Partner will be the sole general partner of KUE and will hold approximately 1,000 General Partner Units ("GP Units") in KUE, representing approximately 0.04% ownership in KUE. The economic interest in KUE represented by the Common LP Units and the GP Units will be reduced by the Profits Participation LP Units as described below under "Distributions." Assuming that 1,000,000 Units are sold to Investors by March 31, 2007, and that the accrued dividends on the preferred limited partner units are paid in cash, KUE LLC, controlled by the Principals, will hold approximately 1,530,000 Common LP Units representing approximately 60% ownership in KUE and 1,530,000 Class A Shares. The Common LP Units owned by KUE LLC will not be transferable, except (i) to the Principals; (ii) to affiliates of the Principals and/or (Hi) to family members and/or charitable organizations in connection with the Principals' estate planning unless combined with the corresponding percentage of Class A Shares to form Units and transferred in the form of Units in accordance with the Limited Partnership Agreement. Knowledge Universe Holdings LLC, a Delaware limited liability company ("KUH LLC") controlled by the Principals, will hold 900 Class B ordinary shares of the General Partner (the "Class B Shares"). The Class B Shares held by the Principals and their affiliates will not be transferable, except to (i) the Principals; (ii) to the affiliates of the Principals; and/or (Hi) to family members and/or charitable organizations in connection with the Principals' estate planning. The Class B Shares will automatically convert to Class A Shares if the Principals' aggregate direct and indirect economic interest in KUE is less than 15% of the outstanding Partnership Units (as defined below) of KUE. A limited liability company ("KULG LLC-1"), of which Knowledge Universe Learning Group LLC, a Delaware limited liability company that is controlled by the Principals ("KULG"), and certain other persons 116 designated by KULG are members, will be the holder of the Profits Participation LP Units (the "Profits Participation Limited Partner") with the economic rights as set forth in "— Distributions" below. KULG LLC- 1 will undertake that no more than 9% of the KUE Partnership Interests outstanding immediately after the final closing of the offering or thereafter will be held directly or indirectly by or for the account of the Principals and their Affiliates through the Profits Participation LP Units of KUE. At least 2/11ths of the Profits Participation LP Units outstanding will be issued to or reserved for the benefit of members of KULG LLC-1 that are not the Principals or their affiliates, and may include employees, officers, directors, consultants and agents of KUE, its subsidiaries and joint ventures as designated by KULG. At each closing of any sale of Units to Investors where the aggregate purchase price of all Units acquired by Investors to date is less than or equal to $1.5 billion (during the Offering Period or thereafter), the Profits Participation Limited Partner will be issued a number of Profits Participation LP Units such that the aggregate shall equal at least 9/11ths of the 11% of "Partnership Units" (Common LP Units, GP Units, and Profits Participation LP Units) that may be represented by Profits Participation LP Units. Additional Profits Participation LP Units will be issued to the Profits Participation Limited Partner, at such time and in such numbers as the Profits Participation Limited Partner will direct, based upon the issuance by the Profit Participation Limited Partner of interests to members of the Profits Participation Limited Partner (who may include employees, officers, directors, consultants and agents of KUE, its subsidiaries and joint ventures as designated by KULG other than the Principals and their affiliates), the vesting schedule of such interests, and whether certain tax elections are made by the recipients of such interests; provided, however, the total number of Profits Participation LP Units shall not exceed a number equal to eleven percent (11%) of the aggregate number of Partnership Units. Any increase in the number of Profits Participation LP Units following the sale of the first $1.5 billion of Common LP Units to Investors requires a majority vote of the Independent Committee. Subsequent to the completion of this offering, KUE may raise additional capital through the sale of equity or debt securities. KUE will not have any preferred limited partner units outstanding upon completion of this offering but KUE may issue limited partner units with preferences over the Common LP Units in the future and may amend the Limited Partnership Agreement accordingly. Since the General Partner will have a nominal economic interest in KUE, the Class A Shares are expected to have nominal economic value. The Class A Shares are, however, intended to provide Unit holders with certain voting and other governance rights in the General Partner (as described further below) which, in turn, will control KUE. 14.4. Admission of Partners to KUE The General Partner may admit one or more Persons as additional Partners of KUE on such terms as the General Partner will determine. Upon the admission of additional Partners, the capital accounts of the Partners will be increased or decreased, as the case may be, to reflect the gross asset values of KUE's assets pursuant to Regulation Section 1.704-1(b)(2)(iv)(g). The amount of any such increase or decrease will be allocated among the Partners who were Partners immediately prior to the admission of additional Partners as if such increase or decrease constituted income or loss, respectively, in accordance with the allocation provisions of the Limited Partnership Agreement. Not in limitation of the foregoing, Investors admitted during the Offering Period after the first closing of this offering and after September 30, 2006 will pay an additional amount accruing at a rate of 0.67% per month calculated from the first closing date of the offering (pro-rated for partial periods) for each Common LP Units purchased, which will be distributed promptly to the holders of Common LP Units outstanding prior to such admission in proportion to the number of Common LP Units held by such holders. 117 14.5. Management of KUE and the General Partner; Voting Rights The General Partner will manage and operate KUE. Investors will have no voting rights on matters affecting KUE business with respect to their Common LP Units in KUE because the Investors will be limited partners of KUE. Notwithstanding the foregoing, subject to certain exceptions set forth in the paragraph below, KUE must obtain the consent of (a) the holders of a majority of the Common LP Units unaffiliated with the Principals to amend the Limited Partnership Agreement in a manner that is adverse to the Common LP Unit holders and (b) the holders of at least 90% of the Common LP Units unaffiliated with the Principals to amend the "Equal Merger Consideration Provision" described herein. In addition, the General Partner may not take any action to (a) alter or add to its Articles or (b) alter or add to its Memorandum with respect to any objects, powers or other matters specified therein that would adversely affect the rights of holders of Class A Shares without the affirmative vote of the holders of a majority of the Class A Shares. Notwithstanding the foregoing, the General Partner, acting reasonably and in good faith, may amend the Limited Partnership Agreement without the consent of any Limited Partner (a) to correct any typographical or similar ministerial errors; (b) to delete or add any provision required to be so deleted or added by applicable law or any government official having jurisdiction over KUE; (c) to cure any mistake or ambiguity, to correct or supplement any provision herein which may be inconsistent with any other provision herein; (d) to take such actions as may be necessary Cif any) to ensure that KUE will be treated as a partnership for U.S. federal income tax purposes; (e) to reflect the admission of any additional Limited Partner and otherwise to reflect such admission or an additional investment by a Limited Partner on the books and records of KUE pursuant to the General Partner's power of attorney; (f) to take such actions as may be necessary (if any) to ensure that neither of KUE or the General Partner (or any subsidiary of the foregoing) will be subject to regulation under ERISA or the Investment Company Act; (g) to take such actions as may be necessary (if any) to ensure that the General Partner (or any Subsidiary) will not be subject to the Investment Advisers Act; (h) to reflect any increase in the number of Profits Participation LP Units approved by the Independent Committee and related changes in allocation and distribution provision; CO to make changes negotiated with Limited Partners admitted in any subsequent closing of the offering, so long as such changes do not, in the good faith determination of the General Partner and with the approval of the Independent Committee, adversely affect the rights, obligations and economic interests of the existing Limited Partners; and (j) to the extent necessary to give effect to partnership interests issued to additional Limited Partners after the Offering Period. The General Partner shall provide prompt written notice of any such amendments to the Limited Partners. Holders of Class A Shares of the General Partner will have one vote per share. The holders of Class B Shares will have, in the aggregate, one more vote than the requisite legal vote required to approve particular matters. In addition, Investors will have the right to elect directors to the Board of Directors of the General Partner as set forth in "— Board of Directors of the General Partner' below. 14.6. Board of Directors of the General Partner The General Partner will have a Board of Directors initially consisting of up to 13 persons. Following the first closing of the offering and prior to the "Initial Listing" (as defined below), the outside Investor (including its affiliates) holding the greatest number of shares in the General Partner at the first closing of the offering will appoint two directors of the General Partner and the holders of the Class B Shares will appoint the remaining Directors. Following the initial appointment of the Board, the Board may, in its sole discretion, increase the number of directors, including to accommodate investors that invest subsequent to the initial closing of the offering of the Units, provided that the outside Investor appointing two directors pursuant to the paragraph above shall have the right to appoint additional directors as required to maintain a ratio of such Investors designees to total Board members of not less than 2/15ths. 118 "Independent Directors" of the Board of Directors of the General Partner shall be individuals who (a) are not (i) a Principal, (ii) a family member of a Principal, (iii) an employee of a Principal or any entity controlled by one or more of the Principals, and (b) meet the definition of "independent director" set forth in Rule 303A.02 of the New York Stock Exchange Listed Company Manual (as if the General Partner, KUE and each of its Subsidiaries were the "listed company") , including any such individuals appointed by the Investors who otherwise satisfy the requirements of this definition. At the time of the final closing of this offering, the General Partner will have at least two Independent Directors. After the Initial Listing and so long as consistent with contractual, listing and licensing obligations, a majority of the board of directors of the listed company will be Independent Directors. 14.7. Initial Listing; Initial Listing Process "Initial Listing" means a listing on a recognized international securities exchange with a substantially concurrent underwritten offering generating gross proceeds of U.S. $200 million or more. "Initial Listing" refers to the Initial Listing of KUE or any successor or any subsidiary of KUE to which substantially all of KUE's assets and liabilities have been transferred or are held. The General Partner may take and cause KUE to take such actions as the General Partner reasonably deems necessary to complete the Initial Listing on the recognized international securities exchange or exchanges selected by the General Partner, including without limitation a restructuring or reorganization or other transaction or asset transfer between or among KUE and any of its subsidiaries. If the Initial Listing involves the listing of shares or other interests of a subsidiary of KUE, in the General Partner's discretion, KUE may (i) retain some or all of KUE's interest in such subsidiary not sold in connection with the Initial Listing, (ii) distribute some or all of KUE's interest in such subsidiary not sold in connection with the Initial Listing to the Partners, (iii) offer Partners the opportunity to exchange their Common LP Units and shares of the General Partner for interests in such subsidiary, (iv) require Partners to exchange their Common LP Units and shares of the General Partner for interests in such subsidiary, or (v) any combination of the foregoing. Each Partner shall cooperate with the General Partner in connection with the foregoing, including, without limitation, (i) by providing any necessary approvals from such Partner for (a) any merger or consolidation of KUE or a subsidiary then permitted by law into an entity that is eligible to effect such Initial Listing and has no other material business, assets or liabilities, or (b) a transfer of all, substantially all or a portion of the assets and liabilities of KUE to one or more wholly-owned subsidiaries eligible to effect the Initial Listing; (ii) by exchanging such Partner's Common LP Units and shares of the General Partner for shares or other interests of the entity to be listed: Op by agreeing to customary "lock- up" (on terms no more restrictive than KUE LLC or its affiliates or any other Common Limited Partner which provides a "lock-up") and other agreements with underwriters; and (iv) by taking such other actions as may be reasonably requested by the General Partner, provided that, in connection with such Initial Listing, no Partner shall be required to contribute additional capital to KUE or the entity effecting the Initial Listing. The economic interests of the Profits Participation Limited Partner shall not be reduced as a result of any actions taken to effect the Initial Listing. 14.8. Mandatory Conversion of Class B Ordinary Shares The Class B Shares will automatically convert to Class A Shares if the Principals' aggregate economic interest in KUE is less than 15% of the outstanding Partnership Units. 14.9. Distributions Cash and other property may be distributed from KUE after payment of ordinary expenses and all amounts currently due on KUE indebtedness, funding capital expenditures of subsidiaries and joint venture, funding operating and other expenses of KUE, its subsidiaries and joint ventures and after the 119 establishment of reasonably necessary reserves as determined by the General Partner. The General Partner will make distributions at such times as determined by the General Partner. Distributions will be made in the following priority: • First, to the Common Limited Partners and the General Partner in proportion to and to the extent of their unreturned capital contributions, but in no case may a distribution pursuant to this bullet exceed a Partner's positive adjusted capital account balance; • Second, pursuant to Subsections (a) and (b) in proportion as follows: (a) to the Common Limited Partners and the General Partner in proportion to and to the extent of their undistributed Preferred Returns; and (b) to the Profits Participation Limited Partner in an amount equal to (i) the number of Units held by the Profits Participation Limited Partner, divided by the number of all outstanding Units other than Units held by the Profits Participation Limited Partner, multiplied by (H) the amount distributed pursuant to Subsection (a) of this bullet, multiplied by (Hi) a fraction to be provided by the Profits Participation Limited Partner; provided, however, that the fraction shall not exceed 2/11ths (unless the Independent Committee has increased the number of Profits Participation LP Units beyond the number initially authorized, in which case the maximum fraction authorized for this purpose would be increased appropriately); • Third, to the Profits Participation Limited Partner in an amount equal to: (a) the number of Units held by the Profits Participation Limited Partner, divided by the number of all outstanding Units other than Units held by the Profits Participation Limited Partner, multiplied by (b) the amount distributed pursuant to Subsection (a) of the above bullet from the inception of KUE, multiplied by (c) a number (expressed as a fraction) equal to 1 minus the fraction used in clause (iii) of the prior bullet for the same distribution (unless the Independent Committee has increased the number of Profits Participation LP Units beyond the number initially authorized, in which case the maximum fraction for this purpose would be modified appropriately), less (d) all amounts previously distributed to the Profits Participation Limited Partner pursuant to this bullet; and • Fourth, to the Common Limited Partners, the Profits Participation Limited Partner, and the General Partner in proportion to the number of Units held by each such Partner. "Preferred Return" means (as to a Common Limited Partner and the General Partner) an amount equal to eight percent (8%) per annum, determined on the basis of a year of 365 or 366 days, as the case may be, for the actual number of days in the period for which the Preferred Return is being determined and be cumulative on the capital contributions of such Partners and shall be calculated from the date of such Partner's capital contribution; provided however that in the case of Common LP Units issued upon the conversion of preferred limited partner units at the initial closing of the offering, that the date of Capital Contribution shall be deemed to be the date of the initial closing of the offering solely for purposes of calculating the Preferred Return. To the extent, at the time of any distribution or income or loss allocation pursuant to the Partnership Agreement, the 2/11ths portion of the Profits Participation LP Units has not then been fully allocated by KULG LLC-1 to employees, officers, directors, consultants and agents of KUE, its subsidiaries or joint ventures, then the distribution or income or loss allocation that would otherwise be attributable to such unallocated portion of the Profits Participation LP Units shall be reallocated among the Common Limited Partners and the General Partner in proportion to their Units for purposes of such distribution or income or loss allocation (including in connection with their Preferred Return). Notwithstanding the foregoing, the Limited Partnership Agreement gives the General Partner the authority to override the distribution provisions of the Limitation Partnership Agreement described above in order to achieve the desired economic arrangement of KUE, which is: (i) first, to return the Partners' Capital Contributions to them; (H) second, for the Common Limited Partners and the General Partner to receive their Preferred Return while the Profits Participation Limited Partner concurrently receives an amount equal to a fraction of the amount the Common Limited Partners and the General Partner received 120 pursuant to their Preferred Return (such fraction to be equal to the portion of the Units held by the Profits Participation Limited Partner attributable to members of the Profits Participation Limited Partner other than the Principals), multiplied by the number of Units held by the Profits Participation Limited Partner divided by the number of outstanding Units other than those Units held by the Profits Participation Limited Partner; (Hi) third, for the Profits Participation Limited Partner to receive an amount equal to a fraction of the amount the Common Limited Partners and the General Partner received pursuant to their Preferred Return (such fraction to be equal to the portion of the Units held by the Profits Participation Limited Partner attributable to members of the Profits Participation Limited Partner who are Principals or their affiliates), multiplied by the number of Units held by the Profits Participation Limited Partner divided by the number of outstanding Units other than those Units held by the Profits Participation Limited Partner; and (iv) finally, for all Partners (including the Profits Participation Limited Partner) to share in the profits of the Partnership in proportion to the number of Units held by them. The General Partner may, in its discretion, when establishing the capital structure of subsidiaries or joint ventures, provide for a capital structure which provides for high-vote and low-vote (or non-voting) securities with substantially equivalent economic rights intended to correspond to the voting and economic structure of KUE (taking into account differences in legal form, such that corporate subsidiaries do not have specified distribution or liquidation rights with respect to common stock). Notwithstanding any contrary provisions below addressing equal merger consideration, to the extent securities of an entity corresponding to the voting structure of KUE are to be distributed to the Partners, the high-vote securities shall be distributed to KUE LLC for purposes of maintaining the voting structure subsequent to such distribution, as long as the securities otherwise have substantially equivalent economic rights and the high-vote securities have mandatory conversion features equivalent to the mandatory conversion features of the Class B Shares of the General Partner (as discussed below), it being understood that securities with high-voting rights shall not be deemed to have a higher economic value than securities with limited or no voting rights solely by reason of the disparity in voting rights. 14.10. Allocations of Income and Losses In general (and subject to certain special tax and regulatory allocations), income and gains of KUE will be allocated to the Partners in the following priority: • First, to the General Partner in an amount equal to the losses previously allocated to the General Partner pursuant to the third bullet in the losses allocation from the inception of KUE, less all