Learn how to use BEE as a strategic advantage:

Want to learn how to make BEE into a strategic advantage?

You’re not alone: we’ve been asked many times if we’d share our experience in finance and BEE to help business owners and their advisors better understand how to make BEE into a strategic advantage.

So we’re planning a series of 1-day workshops in the major cities of SA, for Oct/Nov this year.

It will be a super experience-transfer workshop, where we’ll really unpack things for you.

You’ll learn:

  • Why BEE exists and why it’s not going away anytime soon
  • How the low-growth economy increases the importance of BEE
  • What the different scorecard elements really cost, vs the returns you can expect.
  • The advantages of an ownership-first BEE strategy
  • How to survey your customers and understand the ROI from BEE
  • Why buying/selling shares in private companies is tricky, and why BEE makes this harder still.
  • Common issues in BEE deals, including financing, tax and control…frustrations and fronting
  • What the ideal BEE looks like
  • The different ownership types allowed in the codes
  • The pros and cons of common ownership structures
  • How to finance BEE deals
  • How tax trips up many deals, sometimes years down the line.
  • How to get out of a BEE deal
  • Dealing with the BEE commission: what to expect.
  • Verification: common pitfalls & how to prepare
  • Sector specific issues
    …and much more.

If you’d be interested in this, simply email us and we’ll stay in touch. More formal communications to follow…

Part 9 – The BEE investment decision

The BEE investment decision

Is ownership the cheapest form of BEE?

One of the most highly experienced BEE consultants we work with said recently that in her opinion ‘BEE ownership is the cheapest form of BEE and makes more sense than anything else on the scorecard’.

How true is that statement? As a recap, transformation is measured across a variety of scorecards, each of which has different high-level targets:

  • Ownership (25.1% target for you, but your customers need to buy from 51% BEE owned suppliers)
  • Management control (various incentives for employing black people at different levels of the company, but you can think of it as 25% to 51% of your wage bill, which can be 50% of your total expenses)
  • Skills development (3% of the leviable amount – your HR spend – say 1.5% of turnover)
  • Supplier development (1% NPAT)
  • Enterprise development (1% NPAT)
  • Socio-economic development (1% NPAT)

What’s clear about these scorecard elements is they hit the finances of the business at different levels: Management control speaks to the salaries and wages bill – an expense; skills development is a turnover related expense (and is immediately a bridge too far for many lower margin businesses). These are before-tax expenses and affect the profitability of the company. Once a business has generated profits and then paid its taxes the other scorecard elements come into play – costing 3% of NPAT. Lastly, any BEE ownership takes a proportional share of dividends declared (less any cost of financing the deal – learn how this works later in our series of articles).

The question then, is whether it’s better to spend money from the business on various scorecard elements, or share profits with BEE owners?

Once you’ve done the analysis suggested in our previous article, you’re in a position to determine the ROI from any BEE investment you make. For this next step, you’re going to need to build a DCF (discounted cash flow) valuation model (or you can plug your numbers into our model). Taking this approach puts you in a different league to the majority of companies who ‘do BEE because their clients demand it’ – you’ll actually be making an informed investment decision…and the answer is not always what you may think.

An illustrative calculation example:

Note that we’re illustrating this discussion using the generic scorecard and ignoring the sub-components of each (e.g. how much of ownership goes to black females). These details don’t impact the calculations. We’re also only working with EMEs and QSEs here, as Generic companies need to comply with all elements of the scorecard, whereas a 51% black-owned EME or QSE can get automatic level 2 status and leapfrog the competition.

WhiteCo are considering transformation

Let’s illustrate our example with the story of ‘White Co’:

WhiteCo is a family business that manufactures special widgets – the business makes R5M PAT from a turnover of R30M (i.e. it’s a QSE, albeit very profitable). While the widgets are used across industry most of the buyers, in turn, supply large SOEs or SOCs and so there is a lot of pressure for WhiteCo to transform.

Against all of this, there are 3 other players in the market, all of whom make slightly different but practically interchangeable widgets. One is already level 3 BEE, one is level 5 (same as WhiteCo) and the other doesn’t support BEE and will never do so (WhiteCo knows this because the company is struggling to get new work and staff have been sending their CVs…).

WhiteCo wants to use BEE to increase its competitiveness, but they are uncertain if the investment in BEE is worthwhile.

So, here’s the high-level analysis they run:

Can they ignore BEE?

The first question is what happens if they do nothing? Firstly, with the overall SA economy not growing and with likely export markets already dominated by China, WhiteCo’s profitability depends almost entirely on their local market share. Based on discussions with customers, management determines that unless they get to at least level 3, the business will lose 15% of sales per year as customers shift spend to the level 3 BEE Co. This trend would be expected to continue, with the result that WhiteCo would be almost worthless 5 years from now.

How much would BEE help them grow?

The second question is what would the impact of getting the right level of BEE be? Based on discussions with customers, management realises that if they can get to Level 2, they’d have a real competitive advantage. Customers promise an extra 10%-20% of sales if they get to level 2, depending on how Level 2 is reached.

Which scorecard lever should they pull?

Ownership is a priority element for your customers, so they reward it more highly: WhiteCo are told by a number of their customers that ownership is rated more highly than the rest of the scorecard and that the target is 51%. They work out that they can grow by 20% if they achieve 51% ownership, but only 10% if they get to level 2 by non-ownership means. (The reason for this is that ownership of suppliers is important in how it counts towards to big company’s own scorecard).

Using the DCF valuation model as the basis for comparison:

To determine which path is better, the WhiteCo Financial Director runs a DCF (discounted cash flow) valuation analysis of WhiteCo, comparing the costs of complying with the different scorecard elements. Of particular interest is ownership – because they know that as a QSE they can get an automatic level 2 by getting 51% black ownership and don’t have to spend on any other scorecard element until they reach the Generic category. Getting this right would free up cash for expansion, or would it?

These are the key growth and discount rate assumptions in the model:

  • The business will contract at 15% per year if it does nothing about BEE, whereas
  • It will grow 10% by getting to level 4 without ownership, and
  • It will grow by 20% if it achieves 51% ownership and level 2.
  • These numbers could be a lot more extreme – our survey respondents suggested that no getting to 51% ownership or level 2 would hit their business by up to 50% and that growth of more than 50% would be possible in some circumstances. YMMV.
  • Lastly, from a valuation perspective, we discount cash flows at a rate of 25% pa (implying a 4X PE ratio, a bit generous but using this number doesn’t affect the relative difference between scenarios).

Note that we have a standard model that you can use if you’d like to plug your numbers in (and not have to do the hard work of building the model).

Valuation scenarios:

  • Doing nothing: If WhiteCo does nothing about BEE, it declines in value and is currently worth R16.4M to shareholders. Note that a valuation of R16.4M is lower than R20M (PE of 4*PAT of R5M) – because the business isn’t growing. (We will address the zero-sum nature of BEE in another article, and manipulation of valuations in yet another).
  • Getting to Level 4 without ownership: If the business can get to level 4 using the non-ownership scorecards, then the business grows in value to R23.7M, all of which is owned by the existing ‘white’ shareholders. Note that this means the value of the business has gone up by about 50% due to BEE. This, of course, has come from the decline in value of the other market players. In a zero-growth economy, BEE is zero-sum by definition…Note that it’s impossible for the business to get higher than level 4 without ownership because ownership is a priority element and without it, the score achieved via the rest of the scorecard is discounted a level.
  • Getting to level 2 via ownership only: If the business can get to level 2 using ownership only, then it avoids all the operational costs of the rest of the scorecard and the business grows to R37.3M in value, so this looks like the best option for the value of the business as a whole, but the question is how much of this value goes to the existing shareholders and how much to the BEE owners.

Who gets what?

The truth is ownership deals are complicated and ‘who gets what’ depends on the financing mechanism used.

The simplest example is a cash deal: Assume for a moment the BEE shareholders bought 51% at the pre-BEE valuation of R16.4M, so they paid R8.2M in cash (this very rarely happens) and those shares are now worth R18.6M and they’ve made a profit of R10.45M on an 8.2M investment. Not bad work if you can get it.

The ‘white’ shareholders have received R8.2m in cash (again, this is highly unusual) and have 49% of the business which together is worth R26.5M. A big jump over the R16.4M the business was worth in total before the deal, and more than the R23.7M their shares would have been worth by doing the ‘non-ownership’ BEE stuffs.

Again, this is an illustrative example only, and the differences between the scenarios are deliberately quite large. Sometimes it’s not a clear cut, but either way, you need to do this analysis to understand which is the best investment decision to make.

Some caveats:

Whereas complying with the non-ownership elements of the scorecard is really about where you spend money and which service providers you choose to spend your money on, which you can change over time if you’re unhappy, ownership is more emotive. Many entrepreneurs/business owners worry about a loss of control. They inherently object to someone else having a majority stake in the business (ideology aside) and in most cases have an unwarranted view of what this means. Sometimes it’s just easier to do the non-ownership things, or ignore BEE altogether, than face up the real nuts and bolts of transformation and specifically what it’s like to have investors (rather than partners) in your business.

Importantly, we’ve ignored tax in these scenarios. The non-ownership scorecard spend/points is either calculated on turnover or NPAT (i.e. tax effects are built-in already and comparison between scenarios is valid). On the dividend side, we compare all scenarios in the same way (i.e. ignoring tax) and the comparison is valid. In real-life, your tax structuring will determine your effective tax rate, but the relative difference between scenarios would be the same as we present here.

What would an even better deal look like?

Our analysis would suggest that ownership is a better way to achieve level 2 BEE points than compliance with the rest of the scorecard combined.

At Tusker, we’ve developed a better way of doing ownership deals, which complies with letter and spirit of the BEE act and using the same numbers above would:

  • Leave the original shareholders with R23.3M of shares in WhiteCo, and
  • A separate investment of R8.1M in a business that is 25.1% BEE owned
  • i.e. R31.4M in total.
  • This is nearly twice the value of the entire business before BEE, and 50% better than the ‘non-ownership’ deal.
  • The same deal structure keeps you in effective operational control of the business and lets you achieve 100% ownership for the same cost as 51% (there are many benefits to being 100% BEE owned in this way).
  • Our structure also includes a built-in option to exit partially/entirely down the line.
  • Lastly, the deal can be unwound if the BEE act magically disappears (not expected but our clients ask about this).

Want to get your BEE strategy sorted?

Please complete the form below and we will contact you.

Part 1 – Executive Summary

BEE business

 

All businesses operating in South Africa must decide what strategy they will follow with regards to Black Economic Empowerment (BEE) – a set of laws that aim to ensure political stability through meaningful participation by black people in the economy.

Although unpopular, BEE isn’t going away soon – the transformational need is still very much there, and none of the major political parties in our recent elections has called for its’ abolition. Instead, we expect the BEE landscape to become more onerous and increasingly militant. Our prior predictions about the increasing emphasis on 51% flow-through ownership have been proven accurate with the changes gazetted on 31 May 2019.

While compliance with the BEE Act is entirely voluntary, in reality, the government uses its’ immense spending power to push BEE compliance down to the big companies that deal with the government, who in turn push BEE requirements onto their suppliers. BEE is effectively unavoidable unless your business is almost entirely offshore-focused or has an offering so unique that customers have no choice but to buy from you.

Every company must choose

Every company must choose how to achieve a BEE level that will make them competitive, as measured against a scorecard which depends on both company size and industry sector. BEE requirements become increasingly onerous as a company grows.

The different parts of the scorecard lead to a strategic choice as to how a competitive BEE score is achieved:

  • Is it better to spend 3% of your salary bill on Skills Development? or
  • Spend 3% of NPAT on Supplier Development/Enterprise Development/Socio-Economic Development? or
  • Employ black people in executive and senior management? or
  • Transfer a substantial ownership stake (25,1% to 51%) to black people?

The correct answer requires detailed financial analysis, with the starting point being that the benefits of the chosen BEE strategy must outweigh the costs and risks, or it’s better to do nothing.

The tool to use in understanding this is a Discounted Cash Flow valuation model of the business – it allows understanding as to how changes in sales (downwards due BEE non-compliance or upwards at different rates depending on the BEE strategy chosen – see below), changes in costs (there is always a cost to BEE compliance), and changes to the discount rate (due to the increase/decrease in risk resulting from the chosen BEE strategy) affect both cash flows and the value of the firm. By using this approach, you can understand the true tradeoffs between spend on different scorecard elements and/or the impact of different levels of BEE ownership, allowing you to make an investment decision.

Using this approach, it quickly becomes apparent that not all BEE is equal, and that BEE ownership has special value because of these factors:

  • Ownership is a priority element. Minimum scores must be obtained or else a businesses’ overall scores are discounted a level.
  • Big companies must procure from 51% BEE-owned suppliers to get the most points on their scorecards
  • For companies under R50m sales, achieving 51% BEE ownership achieves an automatic level 2 meaning that spend on the rest of the scorecard can be saved.
  • Companies above R50m struggle to get higher than a level 5 unless they’ve complied with the BEE ownership requirement.

The end result is BEE ownership drives more sales, better payment terms and value creation than all the other scorecard elements combined. We invite you to plug your numbers into our model and see for yourself.

In a low-growth economic environment (which we expect to continue for the foreseeable future) BEE ownership is one of the few levers one can pull to achieve sustainable competitive advantage.

Doing a legitimate BEE ownership deal isn’t easy:

99.9% Of South African companies operate in private-capital markets where transferring ownership is incredibly difficult, to begin with. The starting point of any deal is a solid relationship with the existing shareholders (often the founders) of the business – whose expectations are far more ‘partnership’ than ‘shareholder only’. The separatist legacy of Apartheid now makes it very hard for black and white businesspeople to find one another – trust takes time, always. On top of this, information about the company is hard to come by, each transaction must be negotiated with point-in-time valuations and negotiated payment terms. Legal agreements are complex, and shares must be held for a long time. All of these factors increase risk and drive down valuations.

BEE deals add further layers of complexity: ideological and partner-search issues aside, the biggest problems are fears around giving up control and that most potential black partners simply do not have the cash available to buy the shares on offer. The result is that over 50% of BEE-deals are vendor-financed. Risk is increased too because neither the buyers nor sellers typically have much experience in these types of transactions; advice from BEE experts, attorneys, accountants and tax experts is recommended.

However, BEE ownership offers strategic advantage; a variety of structures can be used to achieve BEE ownership, including:

  • Broad-Based and Employee Share Option Schemes
  • Private equity funds
  • Trusts
  • Options and share warrants
  • Preference shares

Each must be considered in terms of compliance with letter and spirit of the BEE Act, resulting control of the business, desired impact (broad/narrow), likely impact on sales, costs and time to conclude the deal and what’s required to manage it going forward. Tax consequences have to be very carefully considered as there must always be enough cash available to pay taxes triggered as a result of capital gains or income. Tax has tripped up many BEE deals, often years after the conclusion.

While BEE deals can be complex, the truth remains that BEE ownership offers the highest ROI compared to spend on the other scorecard elements. The trick then, is how to reduce the complexities of a BEE deal to the point where it’s a no-brainer. This is where Tusker comes in.

Tusker’s BEE solution

Tusker is a BEE private equity fund. We have taken great care to develop a unique structure that offers 20%-100% legitimate BEE ownership for any business with audited financials and sales >R2.5M. A Tusker deal can be concluded in <3 months and does not mean giving up day to day control of your business. In some cases, Sec 12J tax incentives also apply. The Tusker structure offers the highest ROI of any BEE investment your business can make. It will give you the 51% BEE ownership (or more) you need to out-compete your peers and create sustainable competitive advantage in the SA market, all while fully complying with letter and spirit of the act and increasing your shareholder value.

The bottom line is that if achieving your desired level of BEE ownership would increase the value of the business by more than 10% then Tusker is a no-brainer.

We’d love you to join our herd.

 

 

Continue to read Part 2 – The need for BEE.

 

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Part 8 – BEE Customer research

Cost of businessYou would probably be surprised to know that most of the companies we meet at Tusker ‘want to do a BEE deal’ but haven’t figured out whether it’s actually worthwhile or not.

Without this perspective, making an investment decision is near impossible; any proposal to do such likely to get shot down by shareholders or the board.

How do we measure whether BEE is a worthwhile investment?

The simple answer is that if BEE is worthwhile, the value of your shares in your business should go up. Business valuation is about future earnings, discounted to today by the expected risk.

Doing a BEE deal should ideally increase earnings potential and reduce risk. Not doing a BEE deal may reduce earnings potential and increase risk (as is the situation many of our potential customers find themselves in). Remember than in business valuation terms, even a small change in sales growth rates or a small reduction in risk (cost of capital) can make a major change to your valuation.

So how do we analyse the future earnings side? or the risk side?

The aim here is to understand (a) the cost of doing nothing, (b) the value in achieving different BEE levels, and (c) the value of achieving different BEE ownership %. There are several components to determining value, as you’ll see below.

Start with your Internal analysis:

Here is guide as to how to do it so that you can make more confident decisions:

  • Draw up a list of all your existing clients and prospective clients. Depending on how “80:20” your business is, this could be only a few clients or many. Make sure your list includes those who are most desirable to you, and/or those with the biggest potential impact on your business (if they fired you, or if they grew your account).
  • For each of them, make a column for existing and potential future products/services that you could sell to them, and make a column for their current payment terms.
  • For each of these, estimate how much you will sell to them if you do nothing.
  • Then consider how much you could sell to them at each of the different BEE levels. Perhaps cover off from level 5, 4, 3, and 2 to make it simpler. Understand that these levels would be achieved mostly via the non-ownership elements of the scorecard.
  • Do this for year 1, year 2, and year 3. It’s probably too fuzzy to go any further than that, but this analysis for these 3 years will force your mind to interrogate what is realistic.
  • Put a confidence level against each number – how certain are you to achieve these numbers
  • Sum the (totals*confidence) for each year.
  • You now have a rough idea of how much business different BEE levels can help you achieve.
  • Now do the same analysis, but with those levels achieved via 25,1%, 51% or even 100% BEE ownership. Keep in mind that for your clients, procuring from 51% BEE owned clients (effectively a level 2 for most businesses) does a lot more for their scorecard then procuring from companies who are level 2 but less than 51% BEE owned.
  • NB – the sales you get from a BEE score achieved through ownership is likely to be very different to that achieved from the other scorecard elements (it simply has to be this way, given the way the codes are written – especially the Enterprise and Supplier development scorecards).
  • You now have a rough idea across 4 different ownership scenarios.
  • You can compare the results of the ownership scenarios to the non-ownership scenarios. The numbers are probably speaking quite clearly at this stage but that’s only the internal analysis. It’s a guess at best but forces you to think.

You now need to do the hard part: speaking to your customers.

Repeat the same exercise as above, but actually meet with your customers.

  • Have a confidential discussion with them.
  • Ask them what else (i.e. factors aside from BEE) you need to do to get more business.
  • This is really important – it may be that you actually suck on service/price/quality but you think you’re not getting the work because of BEE. Or it may be you’re really good and it’s only BEE holding you back. Either way you learn and can improve.
  • Ask what happens if you do nothing about BEE – would your business really suffer? by when?
  • Ask who else supplies them and what BEE level they have (they may not tell you exactly, but you’ll get a sense of how competitive it would make your business).
  • Explain how you want to solve their problem (BEE procurement from quality customers they trust).
  • Then repeat the internal analysis you did before, with each client.
  • Ask them what volume of business they would give you if you were BEE level 5, 4, 3, or 2.
  • For this year, next year, and the year after.
  • Ask them what volume of business they would give you if you had 25,1%, 51%, or 100% BEE ownership?
  • Maybe you can’t get much more business but they’ll offer you much more attractive payment terms? You need to push them and understand the difference here too. An extra 30 days cash can make a major difference to a business, and it’s often a concession they’re willing to make to BEE suppliers.
  • See how much you can get at different levels of BEE.
  • Repeat this with each customer. Maybe even different people from each customer, it depends how complex their business is, and how important they are to you.
  • These conversations are great for building relationships, demonstrating intent, and growing your business so it’s never time wasted.
  • Add it all up as before.

Compare results:

Now you’ve got their guesses and somewhere between theirs and yours is the answer as to how much more your business could grow sales at different levels of BEE; from doing nothing to going 100% in. You’ll also know what other levers you can pull to grow your business.

You are now in a position to strategically choose the right level of BEE and almost in a position to understand how best to achieve this level – via ownership or via the other scorecard elements. We discuss this in our next article.

Continue to  Part 9 – The BEE investment decision

 

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Part 7 – Turning BEE into long-term strategic advantage

Long term investment

The story so far:

  • B-BBEE is a set of policies designed to achieve political stability by incentivising the participation of black people in the SA economy.
  • Each company gets a BEE score, measured against a BEE scorecard specific to the company size and industry.
  • The SA government awards contracts based on a combination of quality/price and BEE score.
  • The BEE scores of the big companies that supply government depend on the BEE scores of their smaller suppliers, and so on.
  • In this way the govt uses its’ massive spending power to push BEE onto the economy, without it ever being compulsory.
  • The South African economy is under pressure and barely growing.
  • This means that for a business to grow its SA revenues, it must increase market share. i.e. it’s a zero-sum game.
  • A strong BEE score can become a source of long-term competitive advantage.
  • The question is how best to achieve this, which we discuss below.

Long-term strategic advantage:

Companies that build a “moat” around their earnings become far more valuable over time than their competitors because they earn more with greater predictability and lower risk. They win and their competitors lose.

Typical sources of long-term strategic advantage can be:

  • Intellectual property e.g. patents
  • Long-term contracts with customers/distributors
  • Locking in supply of a rare material/component
  • Restructuring a balance sheet to get cheaper capital
  • Hiring and retaining A-team employees
  • Being awarded an exclusive license e.g. area franchise
  • Reducing the cost of a key input e.g. through using better technology

There are many other examples, but all of these types of advantage can offer a real, long-term source of barrier to competition that puts a business in a far better position than its competitors.

Can BEE be a long-term strategic advantage?

What if we offered you the opportunity for your business to make an investment into infrastructure that would increase the value of your shares in your business by 20%, or maybe even 50%? What if investing in that layer of infrastructure could save you money that you’re already spending on other pieces of infrastructure to do the same job, so you’d have no extra monthly outlay? What if that infrastructure would put you in a more attractive position with clients and be very hard for your competitors to replicate?

For most companies, this would be something very, very interesting.

If it was an IT system, a new sales tool, distribution channel or process improvement then it would be a no-brainer (assuming the cash flows and ROI calcs all stacked up). But what if it was BEE? and specifically BEE ownership?

If you can get past the ideology of BEE (see our earlier articles as to why BEE exists and why it’s not going away) then you can start to treat BEE as any other investment business could make.

Making BEE into an investment decision:

Any investment involves time and money upfront in anticipation of a return at some future date that more than compensates you for the risk involved. If not, don’t make that investment.

It’s exactly the same for BEE: you need to know if sorting how your BEE will improve your prospects. However, there are some important caveats:

  • In a slow-growth economy, BEE is a zero-sum game. Those that have BEE will gain from those that haven’t. The flip side to this is that if you’re the one without BEE then most likely your business is facing a downward trend. If you then sort out your BEE will things go up? or less down than before? or maybe they’ll flatten out at current levels. In many ways, this will be determined by how early you have moved, but how sensitive your clients are to your BEE scorecard, and how quickly your competitors move too.
  • Not all BEE is created equally. Most of the scorecard can be solved by spending money on BEE, but ownership requires changing who owns and controls the business. The ‘spending money’ approach requires continual management of where the funds are spent and making sure the suppliers actually deliver so that you get your points. However, since your customers are highly incentivised to procure from companies with 51% ownership you may find that you can spend all you like on the other scorecard elements but still not get the business.
  • Ownership can lead to substantial savings: EME’s and QSE’s who get to 51% flow-through ownership can also qualify as Level 2 without needing to spend a cent on the rest of the scorecard, until they get to the Generic level (and even then, their clients can treat them as if they still QSE’s for up to another 5 years)!

Understanding whether BEE is an investment decision worth making comes down to understand the likely returns, the likely costs, and the risks/benefits. How to do this is the subject of our next article.

Continue to Part 8 – BEE Customer research.

 

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Part 4 – The SA economy in a nutshell

SA Economy in a nutshell

 

From a population of ±57M people, South Africa has ±3.1M registered companies. So far, so good.

However, only ±850K submit income tax returns to SARS (the balance being considered dormant). 76% of these active businesses are companies with 18.4% individuals. Of these 850K, 774K were registered as VAT vendors but only 504K is registered as employers (i.e. they earn enough to pay VAT and have enough employees to submit PAYE).

The picture gets scarier still – of the 770K companies whose tax returns were assessed:

  • 27% reported negative taxable income
  • 48% reported zero taxable income
  • 25% reported positive taxable income. Of which:
    • 20% reported taxable income below R1M and collectively generate R6.3Bn of Tax.
    • 4% (34K companies) reported taxable income between R1M and R100M. These generate 10x more tax for the fiscus – R63Bn of tax.
    • Only 0.1% of companies reported taxable income of over R100M. The 694 companies in this bracket generate R129Bn of tax for the government – over twice as much as the 34K companies in the previous bracket.

SA company mix

The table above (from the SARS 2018 VAT reports) shows that in 2016 (the latest available data) the 694 companies with income over R100M generated more than twice the tax of the 34K companies in the R1M to R100M income bracket, who in turn generated 10x more tax than the 152K companies with income up to R1M. A very real power law applies.

Note that companies that break-even or are loss-making in a given year are not necessarily terminal but a situation where only 1% of registered companies contribute 95% of corporate income taxes is not reassuring.

SA Company landscape by BEE category:

Since the table above does not fit the EME/QSE/Generic categories used in BEE scores, we refer to the SARS Vat vendor by Turnover table from which we have derived the number of companies in each bracket as follows:

VAT Vendors by BEE size category 2017

Category#Number
27% of reported negative income
EME176,000
QSE34,451
Generic8,946

Only ±15% of the EMEs fit into the R5M-R10M bracket, so this bracket is very skewed towards the smaller companies.

Economic Stagnation:

The economy is under pressure. This demonstrated by the very low GDP growth of 0.8% recorded by Stats SA:

South African annual GDP growth

This overall GDP growth of only 0.8% is not evenly distributed, with construction, mining and agriculture all in a severe recession.

How did South African industries perform in 2018?

Worryingly, STATS SA reports that “the second largest contributor to positive growth was government, which expanded by 1,3%” which is not necessarily a good thing (especially given the known inefficiencies and corruption in all spheres of government).

Source: http://www.statssa.gov.za/?p=11969

The economy is now known to have contracted by 3% year on year in Q1 of 2019, and while a lot about the corruption of South Africa by the ANC is known, there is still a lot to come and it will take brave political leadership to turn South Africa around.

It’s against this backdrop of recession, corruption and identity politics that companies who choose to compete for business in South Africa must decide how best to address BB-BEE.

Continue to read Part 5 – To BEE or not to BEE?

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Part 6 – Unpacking the BEE scorecard

Unpacking the BEE scorecardBEE is customer driven:

BEE trickles down from government tenders to suppliers to their suppliers. The reality is that BEE scorecards matter mostly to your customers. Your scorecard determines how much ‘recognition’ your customers get from trading with you, which means that they are incentivised to spend more with companies who have higher BEE scores.

Different level of BEE (achieved through summing all the scorecard points) result in different procurement recognition levels as per the table below:

BB-BEE status & procurement recognition level

B-BBEE statusBEE Scorecard PointsRecognition level
Level 1≥100135%
Level 2≥95<100125%
Level 3≥90<95110%
Level 4≥80<90100%
Level 5≥75<8080%
Level 6≥70<7560%
Level 7≥55<7050%
Level 8≥40<5510%
Level 9>400

 

What this means is that a business scoring 80 points (out of 109) counts as 100% BEE. i.e. R1 spent on that business counts as R1 of BEE procurement spend. Companies that achieve level 1 count far more (135% recognition of spend) meaning that big customer who buys from that business can afford to spend less (elsewhere) on BEE and still achieve the BEE procurement points it needs. Similarly, a company with only 40 points (level 8) is only worth 10c per Rand of spend. i.e. they may as well be non-compliant.

For most industries, a level 4 is the start at which BEE becomes ‘competitive’. This implies that at least 80 scorecard points must be earned.

BEE points are achieved through the scorecard:

BEE compliance is measured against the BEE scorecard. The scorecard contains different elements, some of which are ‘priority’ elements where sub-minimums apply and varies by company size and industry sector. Reporting requirements (affidavit or specialist audit) also vary by company size. Adding to this, there is the YES (Youth Employment Scheme) which can raise your scorecard by 2 levels. Lastly, the scorecards and legislation around them are subject to change (most recent changes published May 31 2019) making for moving targets. This makes it all a bit confusing, which has created opportunities for a range of specialist BEE advisors and solution providers.

The Generic Scorecard:

In order to keep things simple, in this article we focus only on the generic scorecard i.e. the scorecard for all players not covered by a specific industry sector scorecard (and from which industry scorecards are based). This is not to be confused with ‘Generic’ size companies i.e. those with sales >R50M.

BEE compliance is measured across the following scorecard elements:

Generic BEE scorecard

ElementsPointsBonus Points
Ownership250
Management Control190
Skills Development205
Enterprise & Supplier development404
Socio-Economic development50

 

Given the bonus points, a business can score a maximum of 118 out of 109 points on this scorecard. It’s easy to get confused.

Treatment of different sized companies:

BEE scorecards are broken down into 3 size categories:

  • EMEs (Emerging Micro Entreprises). Turnover <R10M
  • QSEs (Qualifiying Small Enterprises). Turnover R10M to R50M
  • Generic. Turnover R50M+

The main points here are that every EME is treated as an automatic level 4 irrespective of its actual scorecard until it hits the R10M turnover threshold. i.e. a small white company still gets 100% procurement recognition and can effectively ignore the BEE scorecard until it’s firmly on a growth path. However, a 51% black-owned (on a flow-through basis only) company gets elevated to a Level 2, and 100% black-owned to Level 1 – making them far more attractive to customers. The scorecard is self-administered and confirmed by written affidavit. Lying on this affidavit is a criminal offence.

QSE’s are measured against the entire scorecard, and they earn points by sorting out their ownership, management control, spending on preferential procurement, spending on skills development and socio-economic development. They too submit proof via affidavit and no formal audit is required. Again, special compensation exists for QSEs that are 51% black-owned (on a flow-through basis only) as they can become Level 2 without the need to invest/spend anything else on the BEE scorecard. Likewise for 100%/Level 1.

Generic companies are measured against the entire scorecard, get no special dispensation for 51% direct black ownership, and must be audited independently. It’s at the generic level where empowerment really hits the road.

Note that the levels for QSE/Generic vary by industry charter.

Ownership is worthy of special mention:

Since ownership alone counts for 25 points (of 109), it implies that without ownership the best one can achieve is 84 points i.e. a Level 4. However, ownership is a priority element – meaning that unless a sub-minimum is achieved in ownership then the BEE score achieved through other scorecard elements drops a Level. i.e. without any ownership points, the best a company can achieve is Level 5.

While the target in the ownership scorecard is 25.1% (both in terms of voting rights and economic interest) and 25 points are available for this, that changes when one looks at the Enterprise and Supplier Development scorecard from your customers’ point of view.

The Enterprise and Supplier Development scorecard is split into Preferential procurement (25 points can be earned by procuring from ’empowering suppliers’); 10 points can be earned for supplier development contributions; and 5 points for Enterprise Development. While a company need only be 25.1% BEE owned to score full points on the ownership scorecard, most companies need to procure from 51% BEE owned companies to get the points there. The result is that the real ownership target for most companies sits at 51% because that’s the level at which your customers get the most points on their scorecards.

Note that no matter what your BEE score, unless you’re 51% BEE owned you won’t get the preferential procurement points on your customers’ scorecards.

Given this brief introduction to the generic scorecard, we now need to understand how best to achieve those BEE levels. This is the focus of our next article.

Continue to Part 7 – Turning BEE into long-term strategic advantage

 

 

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Part 5 – To BEE or not to BEE?

To BEE or Not?BEE isn’t compulsory, but it’s hard to avoid:

While not compulsory, BEE affects every company trading in South Africa. The reason for this is that the Govt uses its massive procurement budget to force its suppliers to compete on a combination of BEE points and price (BEE counts for 10% or 20% of the tender scoring, depending on the size of the tender awarded). BEE points are measured on a scorecard basis, and a substantial part of this scorecard relates to procurement from other companies with high BEE scores. In this way, BEE trickles down and affects every company operating in South Africa.

BEE remains a choice. Companies may choose to:

  • Ignore BEE.
  • Become minimally BEE compliant.
  • Use BEE as a strategic advantage to win business over the competition and grow faster.

It is important to realise that there will be winners and losers within each group and there will be some overall winners and losers. However, absent any other macro-economic growth, the net effect will be a zero-sum game.

When can you ignore BEE?

Some companies believe that they are unaffected by BEE because they believe that they are either not dependent on business in South Africa, or have a monopoly on the services/products they provide.

Businesses with mainly South African revenues that choose to reject BEE will limit business opportunities to the non-BEE portion of the economy, which is contracting. Ultimately, this would lead to the demise of all such businesses. Although some companies will outlast others, their trading environment will continually deteriorate.

Other businesses believe that instead of facing BEE, they can enter foreign markets and reduce their dependence on South African business. For certain businesses who export their goods or services, this may have an element of truth. However, there is a very real ‘survivor bias’ to data around this – for every public success in going offshore, there are many unseen failures where people lost everything. Entering foreign markets always carries extreme risk.

Rejecting BEE in most situations would be negligent and reckless and potentially breach a director’s fiduciary duties.

Minimal compliance BEE:

Other businesses choose a ‘do as little as possible’ approach regarding BEE: they do enough to be compliant with customer demands and will also typically split their business into two: one that is BEE compliant through which any work is done that requires BEE, and the other that is ‘business as it used to be’. In some cases, the ‘BEE compliant’ division simply ads a layer of cost/pass through as work sold there is still done by the non BEE compliant part of the business.

While this might seem prudent, the reality is that it adds a layer of cost, opens up the business to fronting claims, and achieves little for the country.

Using BEE as a strategic advantage:

The reality of the South African economy is that its’ growth rate will be flat for some time to come. In these conditions, businesses that want to grow can only do so if they take market share away from other competitors. i.e. it’s a zero-sum game.

To compete in a zero-sum world, a business needs a compelling reason for customers to buy from it rather than an alternate supplier i.e. a competitive advantage. The longer this advantage can be sustained the more likely the business is to achieve higher economic returns.

In a world where customers are under increasing pressure to have their BEE scorecards in order, they need to procure from companies who offer them the highest BEE scores too. In other words, the right BEE score can be a very real source of long-term competitive advantage.

The question then is how best to turn BEE from a compliance cost, to an investment in strategic advantage. For that, we need to understand the scorecard elements and what it costs to achieve each of them. Hint: 51% BEE ownership is the trump card.

Continue to  Part 6 – Unpacking the BEE scorecard.

 

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Part 3 – Is BEE going away?

Is BEE going away?

 

We’re frequently asked if B-BBEE is going away. The reality is that it’s here to stay – but likely to be changed/modified along the way. This article is an NB read for those who’d like to believe they can put off BEE until some magical future date – we think (for all the reasons listed below) that this is an unsafe bet. Please read and share. We’d be very interested, as always in constructive comments and suggestions.

The foreign investment imperative:

Zimbabwe recently abolished indigenisation ownership requirements in its mining sector, allowing for 100% foreign ownership. This follows a similar move in Namibia at the end of 2018 – where BEE was scrapped because it wasn’t benefitting the majority. Both countries found that foreign investment had dropped off and attributed this to their laws comparable to our BBBEE laws. Envoys of President Ramaphosa on his drive to drum up investments in South Africa have been told that investment is less appealing because of, amongst other factors, the BEE Act.

Foreigners are not alone in questioning this Act, which is central to South Africa’s transformation agenda. South Africans also question the future of this Act. The questioners range from those waiting for economic transformation and losing faith in the Act’s ability to deliver this, to those who consider the Act racist legislation to blame for corruption and economic decline. They believe, for completely different reasons, that the Act should be scrapped, following the Namibian and Zimbabwean examples.

Policy uncertainty breeds risk:

Many investments have structured around BEE and were the Act to be scrapped, some of these investments would be relooked at. Resentment may be created where the investment is then considered a waste. But, even if it’s not, it’s certain that the investors would see more policy uncertainty. Investors only need to know what the rules of the game are to be able to plan their affairs.

The rules themselves are less important than knowing that they are what they are. The negative investor sentiment around BEE stems from the fact that rules appear to be changed often. Consider the uncertainty around the Mining Charter and the impact on investment, for example. The B-BBEE Commission does not help by making rulings/directives that are non-binding – compared to those by SARS which set clear guidelines for everyone on tax matters. This means that the Commission never introduces certainty, even when issuing practice notes or interpretation guidelines. Nobody can, therefore, every be fully certain that the BEE rules are whatever one thinks them to be.

Change is inevitable:

We have to expect that the Act (and Codes) will change. This is partially an admission of some of the failings in the Act, but it also reflects what a radical idea BEE is. This is a social experiment, never attempted anywhere else in the world. An idea to redress the past without reparations.

Normally, the idea is for the “victor” (the side on the right side of history) to make the other side pay. This happened throughout history and after each war, the loser was made to pay. This was meant to hurt. Germany, for example, made its final instalment ($94 million) on its WWI debt in 2010, almost a century after the Armistice.

The problem with reparations is that the “loser” often feels they are unfair and often this causes significant resentment. The WWI reparations led the economic hardship of the Weimar Republic and the rise of the Nazis. We all know how that worked out. Beware the shallow victory.

South Africa is a massive compromise (AKA negotiated settlement) with a powerful Bill of Rights:

Our Rainbow Nation chose not to exact revenge and reparations in this way. But did demand the restoration of some equity and justice. This included many compromises, which were intended to be just, without being unjust. This was to balance the competing interest groups’ needs, without destroying value for everyone. As with any compromise, this meant that nobody is entirely satisfied with what they got.

The compromises included the establishment of a Government of National Unity, the Truth and Reconciliation Committee, our anthem and most significantly the Constitution of the Republic.

Chapter 2 of the Constitution introduces a Bill of Rights, which is the complete antithesis of what existed under apartheid. The Bill of Rights includes the right to equality, as the very first right, prohibiting unfair discrimination on the basis of, amongst other things, race. Clearly, this marked a complete break with South Africa’s past and echoed what Mandela referred to in his inauguration when he said this beautiful land would never again experience the oppression of one group by another. It’s the same section many refer to when criticizing the BEE Act.

The right to equality is a basic human right. Basic human rights are often called first-generation rights, which are political and civil rights such as the right to be freedom of religion, speech and movement and rights to fair trials and votes and so on. First-generation rights protect citizens from the state, and, although basic was missing for most of South Africa’s history. After the second world war, second-generation human rights developed. These are economic, social and cultural such as the rights to education, housing, health and food.

These are more progressive and also sorely needed in South Africa. But there is a third generation of human rights such as the rights to a healthy environment, group rights and intergenerational rights. These are much more aspirational and largely unofficial. But, South Africa, sought to compensate for previous lack of human rights and included these too its constitution. This is what makes our constitution so different. One-third generation right is the right to economic and social development.

B-BBEE and the constitution:

So how BEE fits into South Africa’s constitutional framework is an important consideration: Clearly if it does not, it would not be allowed and the Constitutional Court would strike the statute down. This has not happened and should give those who say the BEE Act should be scrapped pause because in one way it would be easier to scrap through the Courts than through parliament.

So, we need to consider how an Act such as the BEE Act which clearly is discriminatory and does not treat everyone equally can be upheld when it immediately looks like a contravention of the first human right.

Well, let’s first consider that nothing in the Constitution prohibits discrimination. There is plenty discrimination around that we accept. Pensions, maternity leave, disability parking bays are examples of discrimination, where not everyone is treated equally but which nobody has challenged constitutionally. The simple reason is that the Constitution prohibits unfair discrimination (and not any fair discrimination). So, the first consideration is whether BEE is fair in the context of South Africa. If it is, the Act will not be scrapped in this way.

Most people who think this is unfair have not read the Right to Equality clause in the Bill of Rights which goes to state “to promote the achievement of equality, legislative and other measures designed to protect or advance persons, or categories of persons, disadvantaged by unfair discrimination may be taken.” Therefore, if the BEE Act is intended to promote equality it’s specifically allowed.

The BEE Act has specific objectives in section 2 which include economic transformation for more meaningful participation of black people in the economy. There is no debate that this is designed to advance a category of persons disadvantaged by unfair discrimination. And therefore it’s hard to argue that the BEE Act is unconstitutional by being racist. (This is not intended to be a legal treatise on the Act vis a vis the whole of the Constitution. Rather simply to explain why even though based on racial identity it’s not unconstitutional).

Can B-BBEE be scrapped by a political process?

The only other way for the Act to be scrapped is through the democratic process by the National Assembly repealing it. This could be because the Act has achieved its objectives (and is therefore no longer necessary). The Act’s objectives are not clear – in that it’s unclear what meaningful participation by black people in the economy means or what substantial change in the racial composition of ownership and management is, for example.

There is a quantitative measure of “meaningful” or “substantial”, but it would be hard to argue that the economy is fairly distributed while we have the Gini coefficient of inequality that we do – the worst in the world. We do not believe the objectives have been met, and importantly, no political party would dare to suggest this.

To overturn the Act parliament would have to change policy entirely, coming up with new objectives to better achieve equality. This is quite a specific question and is not to be confused with some of the other perceived problems of the Act, such as corruption which are actually to be dealt with in terms of completely different laws (beyond this scope of this article).

This is a policy decision of the members of parliament to debate and it does not matter whether South Africa has a head of state who is a beneficiary of the Act or not. What do the parties in parliament say?

The 2019 elections in review:

With the results of the 2019 elections now known, it’s worthwhile to reflect on what the manifestos of the ANC/DA/EFF said about BEE:

A third of the 66 page ANC Election Manifesto deals with economic transformation and is the first policy addressed. Nothing suggests that the party is considering scrapping the policy.

The 81 page manifesto of the DA also dedicates a third to the economy, and after public debate the DA agreed that “the approach to Black Economic Empowerment (BEE) as carried out by the ANC, which has only served to enrich a politically connected elite and to dampen economic growth, at the cost of job creation”. They propose instead “Empowerment approaches to provide meaningful redress which eventually realises socioeconomic justice. This approach must codify specific metrics which will signify successful redress (these could include measurables in terms of broader ownership, improved education and skills outcomes, improved entrepreneurial support etc.). As these goals are achieved the need for this approach will fall away.”

This does not sound too dissimilar to the BEE Act other than it that states that the need should fall away. We agree that should be the whole purpose of the Act. But the DA goes on to state “Social protection measures which provide for all currently disadvantaged South Africans regardless of their, or their families’, exposure to past injustice.” This will need to be assessed by the electorate, but in that disadvantages that translate to inequalities are still in the Constitution, how much would really change?

At 166 pages the EFF has the most to say in its manifesto. The EFF seems in this respect to agree with the DA when they state “The few black people who participate in the economy, do so, subject to white approval through a black economic empowerment model that is ostensibly designed to benefit a small number of individuals without ever changing the structural exclusion of the majority.” Theirs is a more aspirational document than the others and seeks the ideal of economic transformation which is more BEE if anything.

Why B-BBEE is here to stay:

Not one of these parties is calling for the BEE Act to be scrapped. But there is an acceptance that BEE has problems. This article is not to explore those. We merely state that the Act is central to our objective of transforming South Africa. Nobody has ever thought this could be achieved without some compromise and cost. BEE is sometimes seen as the cost of transformation (we don’t believe it has to be a cost, contact us to learn how we do things) and even if this is true South Africa should focus on what it’s getting. This goal was spelt in our world-leading Constitution and its third generation rights. This alone separates us from Namibia and Zimbabwe and for as long as it’s the Supreme Law of our land, it will be difficult to completely scrap BEE, but changes should be expected and they might well push harder for BEE rather than make it go away…As for foreign companies looking to invest here – we have a great solution for you too – please contact us.

Given that BEE isn’t going away, the question then is how best to address it in your business…but before we answer that we need to look at the economy overall.

Continue to Part 4 – The SA economy in a nutshell.

 

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Part 2 – The need for BEE

SA inequality worsened since 1994South Africa is the worlds’ most unequal country:

One of the legacies of South Africa’s history of racial discrimination and policies is that a large portion of the population has been excluded from the economy and denied the opportunities to fully participate and benefit from it.

New analysis by the World Bank has confirmed that South Africa is not only the world’s most unequal country, but that extreme inequality has become a major constraint to higher levels of economic growth because it is undermining policy certainty and depressing investment.

The bank’s latest South Africa Economic Update notes that at 0.63, South Africas’ 2015 Gini coefficient was the highest internationally and that inequality had worsened since 1994, despite a decline in poverty.

The bank found that slow growth and high inequality reinforce each other, with inequality fuelling a contestation for resources, which, in turn, increased policy uncertainty and discouraged investment.

“Growing investor uncertainty in the face of strong political demands for redistribution of wealth has contributed to a private investment slowdown in South  Africa” the report highlighted.

Inclusive growth is the way forward

High levels of inequality combined with high levels of political rights, as is the case in South Africa, result in high demand for fiscal redistribution and larger government expenditure.

The World Bank instead suggests a focus on growth, including an increase in product-market competition, a reduction in policy uncertainty and relaxation of migration rules to help fill the gap between the current demand for skilled labour and supply.

“The message here is really about the quality of growth. To be faster, growth needs to be far more inclusive,” the World Bank concludes.

The purpose of the BEE Act:

The SA Government has sought to address the imbalance in wealth and income in several ways. One of the most significant initiatives came with the passing of the Broad-Based Black Economic Empowerment Act[1] (“the BEE Act”) in 2003.

The BEE Act seeks to achieve economic transformation through addressing issues of ownership, skill levels and access to finance for those formerly denied full access to the economy. Those formerly excluded are the primary beneficiaries of BEE and are identified in the BEE Act as “Black People[2]” which are defined as “Africans, Coloureds and Indians” (without being further defined). The secondary beneficiaries of BEE include every South African as giving all access to the economy will increase its size and reduce economic inequalities (and other inequality).

Unfortunately, the BEE Act has yet to achieve its objectives[3] and has faced many challenges in implementation. Examples exist of non-Black People using engaging in fronting, Black People not behaving in commercially reasonable ways and too few Black People benefitting from BEE. Furthermore, the BEE regulatory framework is unique to South Africa and is still being developed. There is uncertainty that has been created from the constantly evolving landscape and the lack of clarity on the intention and interpretation of the BEE Act, which compounded by dedicated but an under-resourced BEE Commission, tasked with ensuring implementation of this mammoth task.

In summary, South Africa needs inclusive growth – until our economy is less skewed and far less skewed across racial lines, the fundamental need underpinning redistributive legislation (such as the BEE Act) isn’t going away. This need will be with us for a long time to come.

Footnotes:

[1] The Broad-Based Black Economic Empowerment Act 53 of 2003.

[2] See section 1 of the BEE Act. Throughout this document “Black People” has this meaning.

[3] For an analysis of BEE ownership see The official stats on bee ownership vs whats really going on and for JSE listed companies see Bee ratings are often no reflection of real black ownership (BusinessLive.co.za)

Continue to Part 3 – Is BEE going away?

 

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