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 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).

 

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