Is ownership the cheapest form of BEE?

Companies with sales under R50M that achieve 51% BEE ownership automatically qualify as level 2 BEE and don’t need to spend on any other scorecard points, those with 100% BEE ownership are automatic level 1. Is it better to go with ownership or spend on the rest of the scorecard? Our analysis shows that ownership leaves far more value in the hands of the existing shareholders than compliance with the rest of the scorecard: in the example below doing nothing about BEE leads to a value of R16.4M – all to existing shareholders. Doing BEE by the other scorecard points leads to a value of R23.7M – all to existing shareholders. Doing BEE via a 51% ownership deal leads to a value of R37.3M for the whole company of which the existing shareholders get R26.5M – by far the best deal overall.

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 have different high-level targets:

  • Ownership (25.1%)
  • Skills development (3% of turnover)
  • Supplier development (1% NPAT)
  • Enterprise development (1% NPAT)
  • Socio-economic development (1% NPAT)

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.

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). 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 determine 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 realise 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.

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).

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 2 without ownership and 20% if it achieves 51% ownership. This 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 cashflows 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).

The value of WhiteCo if it does nothing:

If the business 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 R5) – 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 2 without ownership:

If the business can get to level 2 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…

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.

Now we get to the interesting ‘who gets what’ discussion. The truth is ownership deals are complicated.

The simplest example: 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.

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 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.

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.

The conclusion:

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

But that’s not all….we can do an even better deal through Tusker:

We have 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 their business, and an 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.
  • Keep you in effective control of the business.
  • Let you achieve 51% or 100% ownership for the same cost (there are many benefits to being 100% BEE owned in this way).
  • Can be unwound if the BEE act magically disappears (not expected but our clients ask about this).
  • Includes a built-in option to exit partially/entirely down the line.

Please contact us if you’d like to know more.