The use of preference shares in obtaining Broad-Based Black Economic Empowerment ownership points is becoming more common in the marketplace. Corne van Dyk, Founder of Pretoria based financial services firm, Accountants On Site, explains how a basic preference share structure can help your business work towards achieving the best BEE score.
What are Preference Shares and how do they differ from other shares?
Preference shares are financial instruments that companies can use to raise capital/funds. Similarly, companies can issue shareholders with normal shares or issue bonds in exchange for capital/funds.
Normal shares are considered to be equity due to the inherent risk attached to this type of financial instrument. Normal shares are exposed to the risks inherent to the company issuing the shares. “When the company suffers a loss, shareholders stand to lose their investment. On the other hand, if things go well with the company, these shareholders are rewarded in the form of dividends and capital growth,” van Dyk explains.
Bonds are considered as debt due to the fact that bond holders enjoy some protection from the risks inherent to the company issuing these financial instruments. “During adverse events such as liquidation, bond holders enjoy more capital protection than normal shareholders. These bond holders’ returns are usually also limited to a predetermined rate such as specific interest earned,” says van Dyk.
Preference shares are a hybrid between equity and debt. Depending on their specific terms, the aim of preference shares is to raise funds and give preference shareholders a different risk-and-reward combination than those offered by normal shares or bonds. Preference shares are normally issued at a nominal value (e.g. R100) and at a prescribed rate of interest (e.g. 6%). This rate determines the annual consideration payable to shareholders and at the date of maturity, companies can purchase back the shares at a certain price (e.g. R120).
Alternatively, preference shares can be converted into normal shares. Van Dyk advises that preference shareholders usually cannot vote at a company’s AGM or appoint directors, unless terms relating to the preference shares are not met. In the case that the shareholder’s terms are not met, van Dyk says that preference shareholders would be able to vote at shareholder meetings.
How do companies use preference shares to obtain BEE points?
According to van Dyk, when a company intends to introduce black shareholding, a company valuation needs to be performed. “This valuation determines the purchase price for prospective black shareholders. In most instances, prospective buyers do not have the necessary funds to purchase shares and finance is subsequently needed. Finance may be difficult to obtain and might be subject to onerous guarantee requirements. To circumvent this, current shareholders issue preference shares (equal to the value of the business at that point) to themselves.”
Van Dyk says that preference shares take on the characteristics of debt in the company’s financial records. He goes on to explain that the increased debt, as compared to the assets, diminishes the equity/value of the business and that as a result, prospective buyers can purchase preference shares at a reduced price and the company can reach its black shareholding targets without the need for acquisition finance.
Original shareholders are then guaranteed a fixed return from the company at the prescribed rate (e.g. 6%) until the date of maturity, irrespective of normal shareholding. At the maturity date, the company can purchase back these shares at the predetermined price. Alternatively, the shares can be converted back into common shares, restoring shareholder voting powers.
What are the negative aspects of this structure?
Firstly, says van Dyk, the returns of the preference shareholders are predetermined. “If the company exceeds this rate of return, shareholders are not entitled to the corresponding increase. Secondly, the company’s balance sheet is suddenly laboured with additional debt. This weakens the gearing ratio between debt and equity and will result in increased difficulty in obtaining financing for future transactions.”
In conclusion, van Dyk emphasises the need to approach this structure carefully and with expert assistance. “Every company needs to assess its specific goals, access to resources, and its risks and rewards before implementing this type of ownership structure. It is advisable to seek the counsel of an experienced professional before such deals are concluded.”