Entrepreneurial success, Gamblers’ ruin and partial diversification

As an entrepreneurial business grows, its shareholders face a continual choice around how much of profits should be reinvested. Given entrepreneurial optimism, early or continued success and a while to go before retirement, most re-invest profits continuously for years, if not decades.

The result (if things go well) is that successful founder-shareholders end up with most of their personal wealth tied up in the business – and are very exposed to business risks.

Fire remains a significant business risk

Although successful entrepreneurs tend to be far more risk-averse than popular belief would suggest, we should remember that every business started either eventually goes under or is sold. Few achieve the latter.

Don’t bet everything on the last roll of the dice:

To keep reinvesting all one’s earnings is not too dissimilar from a gambler betting against the house. The statistical phenomenon called Gamblers’ ruin suggests that if a player (entrepreneur) with limited funds keeps betting against an opponent with unlimited funds (that is, a casino, or the global economy), he will eventually go broke, even if the game is fair. All lucky streaks come to an end, and losing runs are fatal.

To get around this, the wise man betting in a casino takes chips off the table at every opportunity…and leaves them off the table, walking out with a share of the winnings earned along the way rather than risking everything on the final roll of the dice…

Entrepreneurs rarely diversify as they go: when we value their shares in the business and compare this to other assets they own then in most cases 99% of their personal wealth sits in the business.

Why entrepreneurs find it hard to diversify risk:

This extreme asset concentration is a global phenomenon.

It exists because it’s really hard to sell a minority stake in a privately-held company: there is no ready market of buyers who want a minority (non-controlling) stake in an illiquid investment where information is hard to get, the price is negotiated over months with loads of legal and accounting complexities (i.e. high transaction costs) and where there’s little external scrutiny or regulation.

The alternative is to sell the whole business; to diversify all in one go and bank on the final roll of the dice. This too is problematic – the business must be built into an asset of value and then sold outright. The process can take years. Valuation expectations are often unreasonable – and when confronted with the reality of a 3 to 4 earnings multiple, many entrepreneurs chose instead to work for another 3-4 years and take all dividends off the table. They remain exposed to the concentration risk along the way.

What has this got to do with BEE you ask?

The BEE act forces privately-held companies to transfer minority ownership stakes – something that’s very hard to do.

It’s hard because the business needs to find trustworthy BEE shareholders to whom they’ll effectively be “married” for a long time. These partners need to add value to the business. They probably don’t have money, so the business will need to vendor-finance the deal…and there’s a valuation, due-diligence, and loads of legal agreements to get through. The BEE shareholders will want to sell at some stage too, in which case the company needs to re-do its BEE deal and the exiting BEE shareholders need to find someone who wants to buy shares in a private company. Not so easy actually.

Our models show that most BEE deals (vendor-financed) destroy value and concentrate risk: selling 25% of a business to a BEE partner typically destroys 30% of value and leaves the entrepreneur with a bit more cash but still with most of their wealth in less of the business.

Join the Tusker herd:

Tusker was initially conceived to be a diversification play for the shareholders of large, privately-held companies; we wanted to create a system to help unlock private capital and reduce the risk to successful entrepreneurs. When we looked at the rules around BEE we realised that we had a superior way of financing legitimate BEE ownership deals that achieved both a far higher ROI (an increase in value of ±40% is typical) and significant shareholder diversification.

If you are looking to diversify risk, and/or do a legitimate BEE ownership deal, then please contact us for confidential analysis of your business.

Are BEE-share schemes discriminatory to your white staff?

Solidarity, a 120-year old trade union with 140 000+ mostly white members, has engaged in a legal strike against the Sasol Khanyisa (BEE) share scheme which it claims is discriminating against white Sasol employees.

Context: the rise and fall Sasol Inzalo:

Khanyisa is Sasol’s second attempt at BEE.

The Sasol Inzalo Scheme was launched about a decade ago when Sasol shares traded around R400 per share and oil cost about $100 per barrel – with predictions that it would go much higher. Sasol effectively offered investors, including its staff (black and white), Sasol shares at R366 each.

At first Inzalo looked very successful: it attracted 208 000 people, making it one of the biggest ever BEE transactions, worth R28 billion.

The deal was straightforward: Investors put some money down (R18 to R44 per share, depending on the quantity) and Sasol arranged bank funding for the balance (using the shares as security). To reduce the risk for the investors the interest rates on the debt were fixed for the scheme’s ten-year life span.

Unfortunately the oil price fell to $55 per barrel and Sasol shares only traded 0.7% up a whole decade later. Shares values need to appreciate substantially to make vendor-finance viable…

In September 2017 Sasol announced that Inzalo would be wound down. Sasol would take the hit on R12 billion still owed to the banks– and with this the market responded by wiping another R7 billion off Sasol’s value the same day.

New schemes for old:

Sasol’s solution is a replacement scheme – Khanyisa – with Sasol offering Inzalo shareholders various options including swapping Inzalo for Khanyisa shares.

Sasol learned from Khanyisa and Inzalo has some key differences:

  • It’s vendor-financed (there are no banks lending the money – Sasol is),
  • It isn’t linked to the Sasol share price but Sasol dividends instead, and
  • The new shares are also only available to Blacks, as per the BEE Act.

The link to dividends (controllable to a large degree by the company) is far less risky than relying on share price (which can be entirely dependent on emotion and other market irrationality) and is a major improvement.

That the shares are only available to Blacks has got Solidarity upset.

Why is Solidarity striking? Why now?

The Inzalo Scheme disappears this week – which explains the timing of the strike.

Solidarity claim that since white Sasol employees cannot acquire shares in Khanyisa (as they could under the Inzalo Scheme) that this is effectively discrimination.

What case does Solidarity have?

While union members’ rights as employees will be determined by our labour laws, within the context of BEE laws things may look different:

There are now three ways to buy/trade Sasol shares:

  • Sasol shares (SOL on the JSE). These are highly liquid, available to anyone and 100% tradable. Sasol is one of the JSE’s blue-chips.
  • Sasol BEE Shares (SOLBE1 on the JSE – Empowerment Section), and
  • Khanyisa shares (which will not be on the JSE and cannot be traded before 2028).

While SOL can be freely traded, the restricted shares look far less attractive: They cannot be bought by anyone (as Solidarity says) and therefore because there is less demand for them, they inevitably will trade at a discount to the SOL shares of which they are a derivative; and the Khanyisa shares cannot be liquidated for ten years.

The issue is really that Sasol is giving funding to Black investors to buy the Khanyisa shares. There is no mention if they will provide funding for White workers to buy Sasol shares directly – but it’s possible.

Will Khanyisa work?

Sasol may still have a loss on Khanyisa as it did with Inzalo.  The difference will be that any loss will not all be at the end (2028) but over the ten years.  It is vendor-finance after all, with all the risks that entails.

An investor decision:

Sasol shareholders voted to go ahead with Khanyisa (not Sasol management): the decision wasn’t taken as an employer, but as an investor and the distinction is important.

Maybe Solidarity will prove that this is wrong in the workplace, but on capital markets, the shareholders (including many foreigners with little SA history) have decided to promote BEE as being good for Sasol. They believe it better for all sorts of reasons. Ironically some will believe it will improve industrial relations. Some will believe it opens markets. Some believe it’s a responsible and sustainable course of action. But the majority voted that BEE is a good investment.

Let’s hope that the economics work out this time.

Where does this leave Solidarity? Time will tell – they are not the first or last group of potential investors in a company to feel hard-done by the easy access to funding that black investors have – but what other options would Sasol have had?



Why do a BEE ownership deal?

There are 2 reasons to do a BEE ownership deal:

  • To contribute towards making South Africa a more stable, racially inclusive economy.
  • To grow your South African business (the reason most BEE deals are really done).

So how does a BEE deal help you grow?

As a recap, the BEE Act is effectively a set of government policies aimed at transforming the economy. The Act sets targets (scorecards) for black participation in ownership, management, skills development, supplier development and more. Companies need to measure and report on their level of achievement against the scorecard agreed to for their industry. In this way government can see the efforts and results of BEE.

The SA government uses its immense spending power (±R800 Billion p.a.) to effect this change – by incentivising its’ suppliers to be BEE. Tenders responses are typically scored out of 100 points, of which either 10 or 20 are based on BEE score with the balance coming from fundamentals (e.g. the ability to deliver the work and the price proposed).

Unless you are supplying highly scarce and unique resources in a non-competitive environment, it’s highly likely that your ability to win a juicy government contract depends on the competitiveness of your BEE score.

The effect of this is that if you want to supply government – the biggest customer in the country – then you need to be able to compete on price, quality and BEE score.

Many companies don’t directly supply government, so why do they need to worry about their BEE scores?

Trickle-down economics and BEE scores

The answer is in trickle-down economics: Government mostly does business with big companies. Big companies are supplied by medium companies who are supplied by small companies. You get the picture – business trickles down.

BEE scores trickle down too, but in a more severe way: the scorecard of a supplier (Company A) to government depends to a degree of the who supplies Company A…and for Company A to get the best BEE points so that it can compete with others for government work, its’ suppliers must have the highest possible BEE score.

51% ownership through a proper structure:

The net effect of this: whereas the target BEE ownership score for your industry may be 25,1% your customer may demand that their suppliers (i.e. you) have ownership scores of 51% because that’s what they need to be competitive. If you don’t then no deal. If not now, then later. If you still think that 25,1% ownership is enough then we have a bridge to sell you…

Further, the nature of the ownership is important and increasingly scrutinised.

We know that big suppliers to government (e.g. SASOL) not only demand 51% BEE ownership from their suppliers but also interrogate the structure by which this is achieved to make sure that it’s not ‘soft’ – i.e. that it will withstand scrutiny by a verification agency and meet the requirements to comply with both letter and spirit of the BEE act.

To grow in South Africa, shrink, or go offshore?

As BEE trickles down (at least 25% of the biggest 20K companies in SA are already 51% black-owned) the pressure mounts.

The choice becomes:

  • Get your BEE ownership sorted out and grow your South African business ahead of your competition.
  • Compete with other ‘white’ businesses for an ever-declining market in South Africa.
  • Go offshore – with all the risks and costs (always underestimated) that this entails.

What we do know is that BEE isn’t going away; that with Zuma out the way and corruption under scrutiny less of the R800 Billion spent by the SA govt will be wasted in future; that ownership is increasingly emphasised above other scorecard measures…and that transferring a minority (or controlling) interest in privately-held companies remains massively challenging on technical, financial and emotional levels.

That’s the why. What about the how?

Black unicorns or Vendor-finance:

If your business is growing fast enough (30% pa plus) to afford their cost of capital, and if you can find one, then maybe a “black unicorn” will emerge from the fog and guide your business to the hallowed lands of level 2. Most companies have no such luck and resort to vendor-financing the purchase of their shares by a BEE counter-party. (For those that haven’t yet experienced this pain, it means you – the seller – lends money to the BEE shareholder so they can buy your shares, which they repay via dividend flow).

Our models show that these deals almost always destroy shareholder value.

The Tusker alternative:

If you are considering a BEE ownership deal, or are unhappy with your existing deal, or are a black shareholder wanting to sell your interest in a privately-held company then we’re ready to help.

Tusker offers:

  • Value creation through governance and growth.
  • Long-term BEE ownership deals from 25% to 51% and/or
  • Significant diversification of shareholder risk.
  • A fair price and a highly standardised deal that’s quick to execute.
  • Structures where you retain effective control.

Please visit Tusker.co.za and complete the contact form – one of our Directors will call you back.