Flow-through and Modified flow-through

In the intricate world of Broad-Based Black Economic Empowerment (B-BBEE) in South Africa, accurately measuring Black ownership is paramount. When ownership structures become complex, involving multiple layers of companies or entities, two key principles come into play: the Flow-Through Principle and the Modified Flow-Through Principle. Understanding the difference between these principles, and when to apply each, is crucial for accurate B-BBEE scoring and strategic planning. This article clarifies these concepts, providing practical examples to illustrate their application.

The Core Problem: Tracing Ownership Through Layers

Imagine a simple scenario: A Black individual, Thandi, owns 50% of Company A, which in turn owns 40% of Company B (the company being measured for B-BBEE). What is the effective Black ownership in Company B? It’s not simply 40%, nor is it 50%. We need a method to trace Thandi’s ownership through Company A to Company B. This is where the Flow-Through and Modified Flow-Through principles come in.

1. The Flow-Through Principle: The Default Rule

The Flow-Through Principle is the fundamental, default rule for tracing ownership. It states that when measuring Black ownership in a measured entity, you only consider the rights of ownership held by natural persons (i.e., individuals, not companies). When those rights pass through a juristic person (a company, trust, etc.), you measure the Black ownership within that juristic person and apply it successively through each layer until you reach a natural person.

Calculation:

The Flow-Through Principle is applied by multiplying the percentages of ownership at each level.

Example (using the scenario above):

• Thandi (Black individual) owns 50% of Company A.
• Company A owns 40% of Company B (the measured entity).

Effective Black ownership in Company B (using Flow-Through):

50% (Thandi's ownership in A) * 40% (A's ownership in B) = 20%

Therefore, under the Flow-Through Principle, Company B would recognize 20% Black ownership attributable to Thandi’s indirect stake.

Example 2 (More complex):

Black person owns 60% of co A
Co A owns 10% of Co B
Co B owns 50% of Co C
Co C owns 30% of the measured entity.

Black ownership in measured entity = 60% * 10% * 50% * 30% = 0.9%

Key Points about Flow-Through:

• It’s the default rule – always applied unless the specific conditions for Modified Flow-Through are met.
• It traces ownership down to the level of natural persons.
• It involves multiplying percentages at each level.
• It applies to all of the ownership indicators (Voting rights, economic interest, and net value).

2. The Modified Flow-Through Principle: The “Once-Off” Boost

The Modified Flow-Through Principle provides a significant advantage in certain circumstances. It allows a measured entity to treat a Black-owned company (at least 51% Black-owned using the Flow-Through Principle) within its ownership structure as if it were 100% Black-owned, but only once in the entire ownership chain. This “boost” can significantly increase the recognized Black ownership.

Conditions for Applying Modified Flow-Through:

• 51% Black Ownership: The intervening company (through which ownership flows) must be at least 51% Black-owned, and this 51% must be calculated using the Flow-Through Principle.
• “Once-Off” Rule: The principle can only be applied once in the entire ownership structure of the measured entity. You cannot apply it multiple times at different levels.
• Applies to Voting Rights and Economic Interest Only: Importantly, the Modified Flow-Through Principle only applies to the calculation of Voting Rights and Economic Interest. It does not apply to the Net Value calculation.
• Cannot use the Exclusion Principle.

Example:

• Black individuals collectively own 60% of Company A (determined using Flow-Through).
• Company A owns 40% of Company B (the measured entity).

Using Flow-Through, Black ownership in Company B would be 60% * 40% = 24%.

Using Modified Flow-Through:

1. Because Company A is >51% Black-owned (using Flow-Through), we can treat it as 100% Black-owned.
2. Therefore, Black ownership in Company B is treated as 100% * 40% = 40%.

The Modified Flow-Through Principle increases the recognized Black ownership in Company B from 24% to 40%.

Example 2 (showing the ‘once-off’ rule):

Black person owns 51% of Co A
Co A owns 60% of Co B
Co B owns 40% of the measured entity.

Step 1: Since Co A is 51% black owned, using the modified flow-through, it can be treated as 100% black owned.
Step 2: Using flow-through, Co B is now treated as 100% * 60% = 60% black owned.
Step 3: The measured entity now has 60%*40% = 24% black ownership.

Keep in mind that the modified flow-through principle can only be applied once in any measured entity’s ownership structure.

Strategic Implications:

• Maximizing Ownership Points: The Modified Flow-Through Principle can be a powerful tool for maximizing Ownership points, particularly for Voting Rights and Economic Interest.
• Structuring Transactions: Companies should carefully structure ownership transactions to take advantage of the Modified Flow-Through Principle where possible. This might involve ensuring that at least one entity in the ownership chain is majority Black-owned (using Flow-Through).
• Due Diligence: When acquiring shares in a company, it’s crucial to conduct thorough due diligence to understand the underlying ownership structure and determine whether the Modified Flow-Through Principle can be applied.
• Net Value Remains Key: While Modified Flow-Through boosts Voting Rights and Economic Interest, it doesn’t affect Net Value. Genuine value creation for Black shareholders remains essential, especially as Net Value is a priority element.

Conclusion:

The Flow-Through and Modified Flow-Through Principles are essential tools for navigating the complexities of B-BBEE Ownership. The Flow-Through Principle is the fundamental rule, while the Modified Flow-Through Principle offers a strategic advantage in specific circumstances. Understanding these principles is crucial for accurate B-BBEE scoring, structuring effective ownership transactions, and ultimately, achieving meaningful economic transformation in South Africa. Companies should seek expert advice to ensure they correctly apply these principles and maximize the benefits of their B-BBEE Ownership strategies.