Part 11 – What makes BEE deals especially difficult?

To understand the ideal BEE deal we need to remove all the reasons why BEE deals currently suck. 

Why BEE deals <can> suck:

Inexperienced transactors:

For all of the reasons previously described, buying and selling shares in private capital markets is complicated and risky. Many of the lessons can only be learned through experience (as we’ve found out!). The problem is that most business owners don’t have this experience, and don’t know what they don’t know. Something that looks simple on the outside quickly becomes a time-sucking, cash-gobbling muck of complexities.

Many business owners are used to ‘doing things themselves’ and resist the valuable advice that experienced accountants, financial advisors and commercial attorneys can bring. Those that employ these services quickly find out how expensive they are; those that don’t generally don’t have happy endings to their story. Even with experienced advisors, issues like tax can deliver a painful smack years after a transaction has been concluded. The reality is that very few have an overall view of the interdependencies of these types of transactions.

Painful, inefficient counter-party search & selection:

One of the most lasting legacies of apartheid is that the older ‘white’ business owners don’t have large networks of ‘black’ peers whom they’ve known for 40+ years and can tap into for potential black investors/partners in their business. It’s the same from other side too: potential black business partners don’t have easy access to trusted relationships with ‘white’ business owners. There is loads of distrust all around.

This means that the already-difficult process of search and selection in private capital markets is made much harder. It’s inefficient and can be a real drag on the entrepreneur/founders’ time. This problem often results in deals taking much longer than normal and still results in some spectacular failures.

Emotional process:

Most entrepreneurs have an emotional bond to the business they founded. It’s “their” business, and its’ success reflects on them personally. Founders often put in late nights, weekends, and sink cash into the business year after year to get it over the hump. Most often, founders start a business without a clear exit in mind, and generally founders don’t think like investors (risk/return) but share a language of toil, passion, commitment, etc.

The outright sale of their business may well be something they theoretically look forward to, but even then their expectations of valuation are often so far from reality that a deal proves impossible. Others have the idea of handing their living, thriving business over to their kids one sunny day. Emigration often kills that ideal too. However selling a partial (let alone controlling share) in a business they founded to a black investor can trigger a wave of emotions and irrational decision making.

Part of the problem is that many founder-shareholders are really looking for a partner, not an investor per se. There is a very real difference. They want someone to take stock with them on a long weekend; someone to get drunk with after closing a new deal. Instead what’s on offer is someone from a different racial and cultural background who is interested in dividends and the capital appreciation of his/her interest in the business.

Getting around this expectation is a crucial step in the transformation of a business. The founder-entrepreneur needs to be emotionally aware, and supported, through this process for it to be a success.

Fears around loss of control:

Many entrepreneurs start a business in part because it gives them a sense of control over their destiny – some see the entrepreneurial route as the antithesis of a corporate-ladder-climbing career rife with politics and corporate BS. In other words, they like being in control.

This comes head to head against the need to transfer 51% of the business to a black investor.

The good news is that, in reality, these fears are most often unfounded. All shareholders should want their value to go up, and directors are obliged at all times to make decisions in favour of the business they direct. There are also many ways to package a shareholders agreement or MOI or company rules to ensure that minorities have a veto on major decisions, or even (e.g. through Tusker) keep the business day-to-day decision making in place while having the board in charge of the larger, strategic or investment decisions. The 51% BEE-owned portion can also be split up amongst different parties (e.g. external investors, staff, a Broad-based trust etc) so that although 51% of the company is black-owned, no single shareholder has outright control.

Financing buyers who have little/no money often destroys value:

The elephant in the room is that most prospective BEE ‘investors’ have no money. This means that in order to conclude a sale and purchase (of shares) agreement, the seller finances the buyer – this is known as ‘vendor finance’ and about half of all BEE deals are concluded in this way. For inexperienced transactors, the idea of the seller paying for the buyer to own shares often feels like an injustice (in reality, vendor-finance is very common in private capital market transactions around the world).

BEE buyers with cash have a real pricing advantage:

There are prospective BEE investors in your business who can pay in cash. However, there are three major problems here:

  • Those that have cash have pricing power. They can squeeze on terms. The end result is that from an NPV perspective the typical cash deal is no better than the vendor financed arrangement more commonly used (we’ve modelled this extensively).
  • Cash requires a return, known in the industry as a hurdle rate. For investments in privately-held companies, this hurdle rate is typically 20% plus. This means that unless your business can grow value by more than this amount for the anticipated holding period then it’s simply unattractive to those with cash.
  • You have to find these investors, and when you do, your business is small and ugly (well, to those BEE investors with cash to invest). They have plenty of larger, more attractive opportunities to put their scarce time into. So even if you can find them the chances are you’re unattractive to them (or only attractive if the deal is far sweeter to them than you’d like).

Tax and lifestyle optimisation:

Smaller businesses are often optimised for lifestyle and to minimise personal taxes. As a business grows the need for proper accounts (a single view of the truth) grows, as does the governance imperative. This part of any business growth story and is unrelated to BEE.

In most cases, what needs to happen is the business owners/founders need to pay themselves a market-related salary and put proper (but SME-appropriate) governance into place. This need not be restrictive, but it does clearly demarcate which costs are for the business and which are for the people who own the business or are employed by it.

The main point here is the bigger picture: building a scalable, valuable business has a far bigger ultimate payday then maintaining a small lifestyle business that has no real value.

Taxes:

Our auditors confirm that a surprising amount of their work comes from helping companies sort out surprise tax bills 2 or 3 years after a BEE deal.

Part of the reason is that BEE consultants are very rarely (never in our experience) tax experts, so nuances are overlooked in deals and the consequences can be very painful years after the deal is done.

In ownership deals common taxes include CGT, STT and dividend tax. As always, it’s NB to consider the amount of the tax, the tax event (i.e. when it’s triggered) and who pays it. As a general rule, the more complex the structure and the instruments used (e.g warrants or options), the more complex the tax. Given that many private companies are a vehicle through which their owners’ taxes are optimised (see above), doing a deal can also remove this layer of insulation from the taxman…and due diligence by the incoming owners may expose legal or tax risks too, depending on how close to the wind the business has been sailing…

Our suggestion is to make sure you get appropriate tax advice on any deal you’re considering.

Broad-based or Direct black ownership?

Faced with all of the problems above, many entrepreneurs default to doing a broad-based deal. Typically selling 25% of their business to their black staff, often via an ’employee trust’. Their logic being that they can’t find a black partner they trust, are going to have to vendor-finance the deal anyway, and would like to look after their staff.

The potential problems with this approach are (a) it’s only a 25% deal so doesn’t come with the advantages of 51% deals (b) if they use a broad-based trust for the structure then it’s highly likely to be attacked by the BEE commission and/or verification agencies (c) unless the black staff own the shares in the personal capacities then it doesn’t count as ‘direct black ownership’, (d) if they issue shares to black staff only then the face potential legal action from white staff because this constitutes an unfair labour practice (see the Solidarity v Sasol case for more), and lastly (e) its very hard to get the required black female ownership where most of your workforce is black male.

Direct black ownership (or structures that offer the same benefit) can be a lot simpler.

Managing expectations: what happens after the deal?

The majority of business mergers fail to add value and the reason for this are problems with post-merger-integration i.e. what happens after the deal and who does what. It’s no different with BEE. The ‘white’ owners now have a business partner they expect to be hands on, but the black investor may want no such thing. The new black owner might have over-promised on his/her ability to get deals, and frustrations may result. The simple advice is to spend as much time and effort building an actionable plan as to what happens in the 12 months after the deal as you spend actually doing the deal.

Despite all these issues (most of which are common to any deal in the private-capital market space), BEE ownership can add substantial value to your business. If done properly…

In our next article we look at what makes an ideal BEE ownership deal.

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