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Options and Warrants

Overview

Options and warrants are financial instruments that give the holder the right, but not the obligation, to buy (or sometimes sell) an asset (in this case, shares in a company) at a predetermined price (the strike price or exercise price) within a specified period. In the context of B-BBEE, options and warrants can be used as a way to grant Black people a future stake in a company, with the potential for recognition under the B-BBEE Codes. However, strict rules apply to ensure that this is not simply a way to delay or avoid genuine ownership transfer.

How does it work normally?

Option: A contract that gives the holder the right to buy (a “call” option) or sell (a “put” option) an asset at a specified price within a specified period.
Warrant: Similar to an option, but typically issued by the company itself (rather than traded on an exchange) and often has a longer exercise period.

In a typical (non-B-BBEE) scenario:

Grant: A company grants options or warrants to an individual or entity.
Vesting (Optional): The options or warrants may have a vesting period, meaning the holder earns the right to exercise them over time.
Exercise: If the share price rises above the strike price (for a call option), the holder can exercise the option/warrant, buying the shares at the lower strike price and making a profit.
Expiry: If the option/warrant is not exercised before the expiry date, it becomes worthless.

What are the BEE rules?

The B-BBEE Codes (Code Series 100, Statement 100, paragraph 3.13) allow for the recognition of Exercisable Voting Rights and Economic Interest before the actual exercise of the option/warrant, but only if very specific conditions are met:

Irrevocable Transfer of Voting Rights: The exercisable voting rights attached to the underlying shares (the shares that would be acquired if the option/warrant were exercised) must be irrevocably transferred to the option/warrant holder for the entire option period. The holder must be able to exercise these voting rights before actually owning the shares.
Irrevocable Transfer of Economic Interest: The value of any economic interest (dividends, etc.) that would be attributable to the underlying shares must be irrevocably transferred to the option/warrant holder for the entire option period and paid to the holder before the exercise of the option/warrant.
Net Value Calculation: The value of the instrument (the option/warrant) must be determined using a Standard Valuation Method, and the Net Value calculation (taking into account any acquisition debt) must be applied. This is crucial – the option/warrant must have real economic value.
No Recognition of Ownership Rights: It is important to note that actual ownership rights are not recognised until the option is exercised.

What’s the spirit?

The spirit is to allow for genuine future ownership transfer, while preventing companies from using options/warrants to:

Delay Ownership: Avoid transferring actual ownership for an extended period.
Create Artificial Compliance: Give the appearance of Black ownership without the substance of real economic benefit and control.
Circumvent Net Value: Avoid the application of the Net Value calculation, which ensures that Black participants have real economic value at stake.

The strict requirements (irrevocable transfer of voting rights and economic interest) are designed to ensure that the option/warrant holder has real rights and benefits before actually owning the shares, making it more than just a paper transaction.

The deal process:

Identify Participants: Determine who will receive the options/warrants (e.g., Black managers, strategic partners).
Structure the Instrument: Define the terms of the option/warrant (strike price, exercise period, vesting schedule, if any).
Valuation: Value the option/warrant using a Standard Valuation Method.
Legal Documentation: Draft an option/warrant agreement that irrevocably transfers voting rights and economic interest to the holder. This is critical for B-BBEE recognition.
Grant: The company grants the options/warrants to the Black participants.
Ongoing Compliance: Monitor and report on the options/warrants, including the Net Value calculation.
Exercise (or Expiry): The holder eventually exercises the option/warrant (acquiring the shares) or it expires.

Pros & cons of this method

Pros:

Potential for Future Ownership: Provides a pathway to future ownership for Black participants.
Incentive Alignment: Can align the interests of the option/warrant holders with the company’s performance (if the share price goes up, they benefit).
Flexibility: Can be structured in various ways (different strike prices, exercise periods, vesting schedules).
B-BBEE Recognition (if structured correctly): Can contribute to the company’s B-BBEE ownership score before the shares are actually transferred, provided the strict requirements are met.

Cons:

Complexity: The legal and valuation aspects can be complex.
Strict Requirements: The requirements for B-BBEE recognition (irrevocable transfer of voting rights and economic interest) are very strict and often difficult to meet in practice.
Risk of Non-Exercise: If the share price doesn’t rise above the strike price, the option/warrant may not be exercised, and the intended ownership transfer won’t happen.
Dilution (upon Exercise): When the options/warrants are exercised, existing shareholders’ stakes are diluted.
Potential for Abuse: If not structured correctly, options/warrants can be used to create artificial B-BBEE compliance without genuine empowerment.

Costs

Setup Costs:
- Legal fees (option/warrant agreement).
- Valuation fees.
Ongoing Costs:
- Compliance reporting.
- Potential payments of economic interest (dividends) to the option/warrant holders before they own the shares.

Gotchas

Failure to Transfer Rights: The most common mistake is failing to irrevocably transfer voting rights and economic interest to the option/warrant holder. Without this, there is no B-BBEE recognition until the option is exercised.
Net Value Calculation: Ignoring the Net Value calculation.
Fronting: Using options/warrants to create a false impression of Black ownership.

Grey Areas

Valuation: Determining the fair market value of the option/warrant can be subjective.
“Irrevocable Transfer”: The precise meaning of “irrevocable transfer” in this context can be debated.

Alternatives

Direct Ownership
Broad-Based Ownership Schemes (BBOS)
Employee Share Ownership Programmes (ESOPs)
Trusts
Private Equity Funds
Sale of Assets
Equity Equivalents (for multinationals)

This provides a comprehensive overview of Options and Warrants in the context of B-BBEE ownership. The key takeaway is that while they can be used, the requirements for B-BBEE recognition are very strict, and they are often not the most practical or effective method.

At Tusker, we know many ways of structuring a BEE ownership deal to achieve legitimate empowerment without losing control or giving anything away. Please contact us for a confidential discussion around your unique needs.