A is for Apple, BEE is for Business (part 2)

Few, if any, South African business owners will fail to recognise the advantages of empowering society to meet its own needs rather than relying on welfare support.

Few, if any, South African companies will question whether Broad-based Black Economic Empowerment (BBBEE) has the potential to boost economic growth and promote global competitiveness.

If this is true, why then is there so much so much negativity among small and medium businesses towards BEE? Is it a matter of resistance, or simply the result of difficulties in implementation?

Part of the answer can be found in the dti BEE Framework Document which states: “When implemented properly and appropriately, the broad-based BEE strategy will ensure that every enterprise operating in South Africa will become both an implementer and facilitator of economic transformation.�

The key phrase here is “when implemented properly and appropriately…â€? Ernst and Young Management Services reported that R42.2 billion worth of BEE deals were made in South Africa during 2003, of which 60%, totaling R25.3 billion, had accrued to the companies of two men – Tokyo Sexwale and Patrice Motsepe. It is also estimated that by the end of 2004, close to 70% of all BEE deals had gone to only six companies. Lionel October of the dti recently insisted on national television that this situation had turned 180 degrees, but few would be naive enough to believe this, or foolish enough to describe the implementation of the BEE strategy to date as being “broad-basedâ€?.

Consider too the actual implementation of the BEE Codes of Good Governance. After years in the making, phases 1 and 2 of the codes were released at the end of 2005 with the final draft expected at the end of this year. Legally therefore, BEE is still on the drawing board, and not binding on anyone except the State and government bodies. The existing codes are subject to change and many believe this will happen, particularly in the case of qualifying small enterprises. Furthermore, as not one verification agency has been officially appointed by dti, today’s BEE verification certificates are legally worthless and the chances are that new ones will be required after the codes are gazetted. How long that will take is anyone’s guess, and as yet no one is saying how long it will take to verify 1.2million companies in this country, or what BEE certification we are to use in the interim.

You might be forgiven therefore had you sat back and just waited for the dust to settle. After all, why waste money on a useless certificate and half-baked advice? Yet this has not dissuaded Government from implementing a preferential procurement policy based on this incomplete BEE framework. Worse still, large corporations have begun to react to the trickle down effect by applying the requirements of the Codes on their smaller customers, even to the point of insisting upon verification certificates from the non-existent BEE watchdog! The result has been devastating for many a small company who has suddenly lost a well-established contract with its principal supplier due to insufficient BEE points, and now faces financial ruin.

How does one respond in such a situation? Horror stories abound of knee-jerk reaction empowerment deals that have gone wrong and the financial consequences. In the rush to become BEE compliant, many small companies panic and do the only BEE thing they know of – that of giving up a slice of the business to the first suitor that comes their way. Unfortunately, like many marriages of convenience, these seldom succeed. Once the honeymoon period is over, business owners struggle to develop a working relationship with their new partners. Conflicts around vision and control soon surface, and tension rises as pre-nuptial promises of performance and growth are not delivered. Where these issues are not resolved, the marriage breaks down and a costly divorce ensues, which at times has damaged the business beyond repair.

An actual example of what can go wrong occurred recently at a small engineering company that supplied the mining sector with hydraulic machinery and parts for underground equipment. With a turnover around R500k per month, this company – call it Newco – was providing its middle-aged, white Afrikaner owner – call him Ben – with a comfortable living. However, it was solely dependant on orders from a few large mines.

About a year ago, Newco was threatened by its single largest customer, a JSE listed Mining house, that unless it became BEE compliant it would receive no more orders. At the same time this same mining house provided the name of a “suitable� black partner. Newco took on this partner, partly in panic, partly trusting in the recommendation, and partly believing that this move would win favour with the mining house.

Initially it seemed like a good marriage. When the new partner started bringing in million-rand tenders for items ranging from overalls to wheelbarrows, turnover immediately went up five-fold. Ben was so excited at the prospects that he arranged an extended line of credit with the bank, pledged his house as collateral, and bought himself a new bakkie. Being relatively unsophisticated in financial management Ben also asked his accountant to move the business across to a new accounting system that was better able to cope with the increased volume of business.

Three months on and business continued to pour in. Newco was now on the list of preferred suppliers for all basic mining requisites, and could hardly keep up with the orders. Their new accounting system was still not in place and Ben wasn’t quite sure of which invoice related to what order, but was confident that his new partner had everything under control. Things continued to surge ahead, until the day his bank called to say that the credit line had been exhausted. Ben was shocked; they were doing so well; what had happened to all the money? He called for a forensic audit, and it took his accountant less than an hour to discover the problem. His report to Ben was brief: “The golden rule in business� he said, “is that if you buy for one rand, you should sell for two; not for seventy-five cents!� With little understanding and experience in costing techniques, his new partner had under-quoted on every tender and incurred losses on each deal. The combination of a lack of business skills, no accounting system and poor management control had brought about a massive accumulation of debt.

When confronted with this situation, the new partner threw his keys on the table and walked out, leaving Ben to face the problem alone. Initially he attempted to trade his way out of the debt with the cooperation of his principle creditors. However his bank was less supportive; in addition to stopping all credit facilities, they laid hold of any money entering the account. With little chance of getting the money, one of Ben’s creditors finally lost patience and put his company into liquidation. Stripped of his business, house and self-esteem, but still owing debts in excess of R0.5m and facing bankruptcy proceedings, Ben has taken a supervisory job in Botswana where he is trying to rebuild his life.

The tragedy of this scenario is that the focus of the broad based BEE strategy is intended to be wider than merely black ownership and control. In fact, the number of BEE points acquired through Ownership is insufficient to get a company onto the very first rung of the BEE compliance and rating ladder. The BEE codes promote a balanced scorecard approach whereby companies are encouraged to change across all seven elements of the scorecard: ownership; management control; employment equity; skills development; preferential procurement; enterprise development; and residual aspects such as corporate social investment.

Unfortunately the State continues to use black ownership as the key component in determining its procurement decisions. Similarly, many large companies have adopted strict and often misguided procurement policies based on a limited understanding and inappropriate application of the Codes. This is evident from corporate procurement questionnaires that focus primarily on ownership and control issues, while ignoring all other elements. For this reason the status given to black ownership in the real world is disproportionate to its value in BEE points; and this has become the overriding and non-negotiable requisite for BEE compliance recognition, irrespective of the intention of the architects of the balanced scorecard. Until this changes, which hardly seems likely, every company will have find a black empowerment partner if it is to be recognised as being BEE compliant.

And herein lies a huge problem for most small private companies – how can it attract a black investor into what is essentially a high risk enterprise? In most cases it will be an owner-driven or family-managed affair, with little management continuity and uncertain sustainability. It will have geared its business to declare the minimum amount of taxable income, and therefore is unlikely to pay out much in profits or dividends. Its growth prospects will be limited and the chances of it ever listing publicly are remote. As a business investment it is risky, and therefore an empowerment deal is unlikely to be financed by the bank without significant guarantees being in place. In the face of such obstacles most small enterprises will have to resort to giving their shares away in order to attract a BEE partner.

The second problem is…who? With demand for BEE partners at boiling point, and the shortage of quality people growing more acute, it is not as if these small enterprises stand much chance of acquiring the right fit for the business. In their desperate need to get a partner many will take on someone who is less than a perfect match – a rash decision that would normally not have been taken, and one that could prove to be very costly. Extracting itself from a bad BEE deal recently cost a family business more than R1.0m in court and legal fees, and caused one engineering concern to close down its business and start again as a new company.

Recognising the difficulties faced by small enterprises, it is reported that the government is investigating how BBBEE can be applied to them in a more practical manner. Talk is that the scorecard may be changed, or the turnover exemption threshold may be raised. Whether this is true remains to be seen, but the longer the delay in releasing the final Codes, the greater the danger of small companies being stampeded into bad BEE deals in order to survive. So it’s time to put an end to the confusion and get the BEE show on the road.