Using Preference Shares for BEE ownership

Overview

Preference shares (“pref shares”) are a class of shares that have certain preferential rights over ordinary shares. These rights typically relate to dividends (a fixed dividend payment) and/or the distribution of assets upon liquidation (priority over ordinary shareholders). In the context of B-BBEE, preference shares can be used as part of an ownership structure, but their treatment under the Codes depends heavily on their specific characteristics. The key question is: do the preference shares have characteristics that are more like debt or more like equity?

How does it work normally?

In a typical (non-B-BBEE) scenario, preference shares:

• Fixed Dividend: Usually pay a fixed dividend, often expressed as a percentage of the share’s nominal value.
• Priority in Liquidation: Have priority over ordinary shareholders in receiving assets if the company is liquidated.
• Limited Voting Rights: Often have limited or no voting rights, compared to ordinary shares.
• Redeemable/Convertible (Optional): May be redeemable (the company can buy them back) or convertible (can be converted into ordinary shares).

What are the BEE rules?

The B-BBEE Codes (Code Series 100, Statement 100, paragraph 3.14) address preference shares as follows:

• Equity-Like Pref Shares: If the preference shares have characteristics that are similar to ordinary shares (e.g., participating in additional dividends beyond the fixed amount, having significant voting rights), they are treated as ordinary shares for B-BBEE purposes. This means the standard rules for measuring voting rights and economic interest apply.
• Debt-Like Pref Shares: If the preference shares have characteristics that are more like debt (e.g., a fixed dividend that is essentially an interest payment, limited or no voting rights, a mandatory redemption date), they are treated as an ordinary loan.
  • If the “loan” (the preference share investment) is from a Black participant, it can be considered in the Net Value calculation (reducing acquisition debt).
• Hybrid Instruments: If the preference shares have a hybrid nature (some characteristics of debt, some of equity), only the portion that represents debt is treated as an ordinary loan. The remainder is treated as an ordinary equity instrument. This requires careful analysis of the specific terms of the preference shares.

What’s the spirit?

The spirit is to:

• Recognize Genuine Equity: Treat preference shares that are truly equity-like as ordinary shares for B-BBEE purposes.
• Prevent Circumvention: Prevent companies from using preference shares to create artificial B-BBEE compliance without genuine economic empowerment. Debt-like preference shares are not a substitute for real equity ownership.
• Acknowledge Funding: Recognize that Black participants may use debt-like preference shares to fund their investment, allowing this to be factored into the Net Value calculation.

The deal process:

1. Structure the Pref Shares: Carefully define the terms of the preference shares (dividend rate, voting rights, redemption/conversion features, etc.). This is crucial for determining their treatment under the B-BBEE Codes.
2. Valuation: Value the preference shares.
3. Legal Documentation: Draft a share subscription agreement and amend the company’s Memorandum of Incorporation (MOI) to create the class of preference shares.
4. Subscription: Black participants subscribe for the preference shares.
5. B-BBEE Analysis: Analyze the characteristics of the preference shares to determine whether they will be treated as equity, debt, or a hybrid instrument for B-BBEE purposes.
6. Ongoing Reporting: Report the preference shares appropriately in the company’s B-BBEE verification.

Pros & cons of this method

Pros:

• Flexibility: Preference shares can be structured with a wide range of terms, allowing for customization.
• Potential for B-BBEE Recognition (if equity-like): If structured appropriately, they can contribute to the company’s B-BBEE ownership score.
• Funding Mechanism (if debt-like): Can be a way for Black participants to fund their investment, with the “loan” being considered in the Net Value calculation.
• Priority for Investors: The preferential rights (dividends, liquidation) can make them attractive to investors.

Cons:

• Complexity: Structuring preference shares correctly for B-BBEE purposes can be complex.
• Risk of Debt Treatment: If they are deemed debt-like, they won’t contribute to the ownership score (except indirectly through Net Value).
• Limited Upside: The fixed dividend may limit the potential upside for Black participants compared to ordinary shares.
• Potential for Dilution (if convertible): If the preference shares are convertible into ordinary shares, existing shareholders’ stakes could be diluted.

Costs

• Setup Costs:
  • Legal fees (share subscription agreement, MOI amendment).
  • Valuation fees.
• Ongoing Costs:
  • Dividend payments.
  • Compliance reporting.

Gotchas

• Debt-Like Characteristics: The most common mistake is structuring preference shares in a way that makes them debt-like, preventing them from contributing to the ownership score.
• Hybrid Instruments: Failing to properly analyze and separate the debt and equity components of hybrid preference shares.
• Fronting: Using preference shares to create a false impression of Black ownership.

Grey Areas

• Determining Debt vs. Equity: The line between debt-like and equity-like preference shares can be blurry, requiring careful analysis of the specific terms.
• Valuation: Valuing preference shares, especially those with complex features, can be challenging.

Alternatives

• Direct Ownership (Ordinary Shares)
• Broad-Based Ownership Schemes (BBOS)
• Employee Share Ownership Programmes (ESOPs)
• Trusts
• Private Equity Funds
  • Sale of Assets
• Equity Equivalents (for multinationals)
• Options and Warrants

This provides a comprehensive overview of Preference Shares in the context of B-BBEE ownership. The key is to carefully structure the preference shares to align with the desired B-BBEE outcome (equity treatment or debt treatment for Net Value purposes).

For many companies, a better structure can be achieved using the private equity rules. Please contact us for a confidential discussion around your unique requirements.