AN EFFECTIVE black economic empowerment deal structure is one that is sustainable in the long term. Too often companies rush to do deals, focusing on the deal itself — the wedding — rather than the relationship with its partner — the marriage.

Structuring an empowerment transaction can be likened to a constrained optimisation problem and the trick — especially for small and medium enterprises — is to keep it simple. Complex structures take more time and can be costly, requiring unnecessary accounting, tax and legal advice.

There is a push now for a greater degree of facilitation by the company looking to be empowered. Common methods include issuing shares at a discount, issuing a free option, providing funding on favourable terms, issuing a class of equity that has a higher guaranteed dividend stream, providing a guarantee to third-party funders or setting hurdle rates (in an earn-out structure) at achievable levels.

The key objective for achieving an effective deal structure is to find the optimal balance between the company, its shareholders and the empowerment partner, all subject to a range of constraints. This balance, reflected in the effective price of the deal — the transaction price after taking into account transaction costs and adjusted for time value of money — may be determined from the empowerment value gap analysis, discussed in last month’s issue.

If the value gap as a percentage of the value of the company is relatively high, the effective transaction price could be lower, apparently favouring the empowerment partner. But in this case to strike a balance it is important to ensure that:

The facilitation costs (in the form of dividend payments to service the third-party empowerment debt, for example, or the interest charge where a company funds the partner) are within the company’s capacity; and

The shareholder facilitation level (for example, in the form of the price discount or shareholder dilution) still ensures adequate shareholder returns over the vesting period.

Similarly, if the value gap is relatively low, the effective price could be higher while the company or shareholder facilitation could be lower.

When structuring an empowerment deal, the main constraints to take into account include funding, regulatory, accounting, tax and legal issues.

The nature and effects of these constraints depend on the industry and factors such as the company’s status in respect of tax, accounting method, profitability and cash flow.

In determining the structuring parameters such as facilitation, dilution, vesting period and empowerment discount, the following factors may be taken into account:

The benefits of having a BEE partner (empowerment value gap analysis);

Timing, such as potential first-mover benefits;

Exclusion of non-South African assets;

Equity ownership targets;

Empowerment entry point (holding company level or subsidiary level);

Guaranteed versus nonguaranteed empowerment (lock-in period and guaranteed vesting level); and

Performance-related empowerment (active versus passive involvement).

Essentially there are four types of structures currently used: equity financing, debt financing, vendor financed and unfunded structures.

In an equity financing structure the company trades its shares for a black-owned company’s assets. The advantage of this structure is that no external funding is required and the company becomes empowered from day one. A limitation is that not many empowerment companies have unencumbered assets and the empowerment party takes the full equity risk at the outset.

In a typical debt-financing structure the empowerment partner raises third-party funding to buy shares, which are pledged as collateral to the funder. This structure is suitable for a company that generates predictable cash flows to service the debt. An advantage is that debt funding is usually cheaper than equity funding but a key disadvantage is that funders have limited risk appetite and usually require additional collateral and/or some form of equity upside.

Vendor-financed structures are popular. The company facilitates the funding for the empowerment partners by providing either a loan or a guarantee to a third-party funder. The advantages include relatively easier access to funding and less onerous terms. The disadvantages are that the company puts its own balance sheet at risk and restricts its ability to raise additional debt.

It is important to note that in the case of a vendor-financed structure, Section 38 of the Companies Act, which prohibits a company from funding an empowerment partner to buy its shares, must be taken into account. But if the deal is done at the subsidiary level, the holding company may give guarantees or provide security to third parties, funders, lend to the partner directly or subscribe for preference shares in it.

In an unfunded structure the transfer of shares is based on value created. A typical example is when a company issues an instrument that has full voting rights but limited economic rights. Economic rights accrue to the partner when the instrument converts to ordinary shares based performance or value realised. Its main advantage is the inherent incentive for the empowerment partner to add value, while a common disadvantage is the potentially long time for the partner to earn full economic rights.

Apart from adopting a sound analytical approach, coming up with an effective empowerment deal structure that supports a marriage with the partner, innovation and a bit of luck are sometimes necessary.

Gounder is MD of empowerment consultancy Taemané Blue Consulting.