Valuation Considerations in BEE ownership deals

Let’s delve into the nuanced valuation considerations and potential manipulations in BEE ownership deals. This is a critical area, often fraught with complexities and potential pitfalls.

Please note that this section introduces some of the ‘gotchas’ we see in our work – “your mileage may vary” so please take care to analyse your own business with the ideas below, and let us know if there is anything else we should add.

1. Value of a Business Without BEE Legislation (The “Theoretical” Value):

• The Hypothetical Construct: This is a purely theoretical exercise. In the current South African context, every business is affected by BEE, directly or indirectly. It’s like trying to value a fish without considering the water it swims in. However, it can be a useful starting point for understanding the magnitude of the BEE impact.
• Valuation Methods: In BEE deals, standard valuation techniques are used:
  • Discounted Cash Flow (DCF): Projecting future cash flows without considering any BEE-related costs or benefits (lost revenue, increased revenue, etc.). This requires making assumptions about how the market would behave without BEE, which is highly speculative.
  • Market Multiples: Comparing the business to similar companies in countries without BEE-like legislation. This is problematic because finding truly comparable companies is difficult, and market conditions differ significantly across countries.
  • Asset-Based Valuation: This is less relevant for most operating businesses, as it focuses on the liquidation value of assets rather than the going-concern value.
• The Purpose: The main value of this “theoretical” valuation is to serve as a benchmark against which to measure the impact of BEE. It’s not a realistic reflection of the business’s actual market value.

2. Effects of BEE on a Business’s Value:

This is the core of the issue. We need to consider both positive and negative impacts:

• Negative Impacts (Costs and Risks):
  • Lost Revenue: As we discussed, this is the most significant direct impact. Non-compliance can lead to the loss of major clients, government contracts, and operating licenses. Quantifying this requires a rigorous probability-weighted analysis. Some businesses have unique products/services and are not impacted by BEE requirements; others are commoditised and BEE points (especially from a preferential procurement perspective) become a competitive differentiator.
  • Increased Costs: Transaction costs, financing costs (dividends, interest), and ongoing administration costs all reduce profitability.
  • Dilution: Existing shareholders’ ownership stake is reduced.
  • Loss of control: In 51%+ deals, the BEE shareholders gain overall control of the company. The value of a block of shares that have effective control are typically given a ‘control premium’ in valuations. Similarly, losing effective control means that the remain shares are proportionately discounted.
  • Management Time and Effort: Dealing with BEE compliance and managing the partnership takes time and resources.
  • Potential for Disputes: Disagreements with BEE partners can be costly and disruptive.
  • Reputational Risk: “Window dressing” or superficial BEE compliance can damage a company’s reputation and expose the business to fronting charges (which include criminal penalties).
  • Regulatory Risk: Changes in BEE legislation can create uncertainty and potentially increase compliance costs.
• Positive Impacts (Benefits and Opportunities):
  • Increased Revenue: Access to new markets (government contracts, preferential procurement), improved pricing power, and enhanced brand reputation can lead to higher sales.
  • Improved Competitive Position: As discussed in the Porter’s Five Forces analysis (see the preceding article on the ROI from BEE ownership deals), BEE can strengthen a company’s position against competitors.
  • Access to Talent: A diverse workforce can bring new skills and perspectives.
  • Innovation: Diversity can foster creativity and innovation.
  • Improved Stakeholder Relations: Strong BEE credentials can improve relationships with employees, customers, communities, and government.
  • Higher Valuation Multiple: A BEE-compliant business may be seen as less risky and more sustainable, potentially commanding a higher valuation multiple.
• Net Effect: The overall impact on value is the net result of these positive and negative effects. A well-structured BEE deal should result in a net positive impact on value.

3. Potential Value Manipulations by “White” Companies:

This is where things get tricky, and ethical considerations are paramount. Here are some potential areas of manipulation:

• Inflating Pre-Deal Valuation:
  • Aggressive Revenue Projections: Overly optimistic projections of future revenue growth, especially in the “Without BEE” scenario, to make the BEE deal appear less dilutive.
  • Understating Costs: Minimizing the estimated costs of BEE compliance (transaction costs, administration costs, etc.).
  • Manipulating Discount Rate: Using an artificially low discount rate in the DCF valuation to inflate the present value of future cash flows.
  • Choosing Favorable Comparables: Selecting companies for market multiple analysis that are not truly comparable but have higher valuations.
  • Asset Revaluations: Revaluing assets upwards (if permitted under accounting standards) to increase the asset base and justify a higher valuation.
• Deflating Post-Deal Valuation (When Exiting):
  • Depressing Revenue Projections: Understating future revenue growth, especially in the “With BEE” scenario, to make the BEE partner’s stake appear less valuable.
  • Overstating Costs: Inflating the estimated costs of BEE compliance.
  • Manipulating Discount Rate: Using an artificially high discount rate to reduce the present value of future cash flows.
  • “Stuffing the Channel”: Artificially boosting short-term sales before the exit to make the business appear more profitable than it is.
  • Creating artificial debt: Taking on debt to make the balance sheet and equity component appear less valuable.
• “Fronting” and “Window Dressing”:
  • Structuring deals that appear to be BEE compliant on paper but do not result in genuine transformation or value transfer to black shareholders.
  • Appointing black individuals to positions without real authority or influence.
  • Creating complex structures that obscure the true ownership and control of the business.

4. Value Brought by “Black” Shareholders:

The value brought by black shareholders goes beyond their financial investment. It’s crucial to recognize this “intangible” value:

• Access to Networks: Black shareholders often have extensive networks in government, business, and communities, which can open doors to new opportunities.
• Market Knowledge: They may have a deeper understanding of the South African market and consumer preferences.
• Cultural Sensitivity: They can help the business navigate cultural nuances and build stronger relationships with diverse stakeholders.
• Reputational Enhancement: Their involvement can enhance the company’s reputation and credibility, particularly with BEE-conscious customers and stakeholders.
• Strategic Insights: They may bring fresh perspectives and strategic insights that can improve the business’s performance.
• Talent Acquisition: They can help attract and retain black talent.
• Transformation Expertise: They may have experience in implementing successful BEE initiatives.

In our experience the ‘value’ brought by black shareholders is often over-sold, resulting in deals that go sour after being concluded. This can be avoided by being very specific about who does what after the BEE ownership deal, and making sure that performance is managed firmly. It’s easy to get caught up in the potential upside of a deal; instead more time should be spent on ‘what happens next’ and ‘what if things go wrong’.

5. “Net Value” and its Tie-In:

“Net Value” is a critical concept in the BEE Codes. It essentially refers to the unencumbered value of the BEE partner’s shareholding. This is designed to prevent “fronting” and ensure that black shareholders genuinely benefit from the deal.

• Calculation: Net Value = (Value of BEE partner’s shares) – (Outstanding debt related to those shares).
• Time-Based Escalation: The BEE Codes often require that the Net Value increases over time, ensuring that black shareholders’ economic interest grows. This is often achieved through a “deemed” or “notional” vendor financing structure, where the debt is gradually reduced over time, even if actual cash repayments are not made.
• Valuation Disputes: The determination of Net Value is often a source of disputes, particularly when the BEE partner exits the deal. This is where the potential for valuation manipulations comes into play.
• The “Once Empowered, Always Empowered” Debate: There’s ongoing debate about whether a company retains its BEE status if a BEE partner exits and the Net Value is realized.

Other Considerations:

• Independent Valuation Expertise: It’s essential to obtain independent valuations from reputable experts, especially in contentious situations. This helps to mitigate the risk of manipulation and provides a more objective assessment of value. Keep in mind that as a director of a business you can be sued by future shareholders if your actions destroy value or increase risk beyond what would have been reasonable.
• Transparency and Disclosure: Full transparency and disclosure of all relevant information are crucial to building trust and ensuring a fair deal.
• Legal and Tax Advice: Expert legal and tax advice is essential to navigate the complexities of BEE legislation and ensure compliance.
• Long-Term Perspective: BEE should be viewed as a long-term strategic investment, not a short-term compliance exercise.
• Due Diligence on BEE Partner: Just as the company is valued, the BEE partner should also be assessed for their ability to add value beyond their financial contribution.

In summary, valuing businesses in the context of BEE ownership is complex and requires a nuanced understanding of both the tangible and intangible impacts of BEE. The potential for valuation manipulations exists, highlighting the need for independent valuations, transparency, and ethical behavior. Recognizing the full value brought by black shareholders, beyond their financial investment, is crucial for building genuine and sustainable partnerships – however for this value to be realised a plan must be put in place before the deal is concluded and managed to completion after the deal is done. Lastly, its important to understand the concept of “Net Value” (central to ensuring that BEE deals result in real economic empowerment especially where shares are debt- or vendor-financed).

At Tusker, we are valuation experts and would love to help. Please contact us for a confidential discussion on your unique BEE ownership requirements.