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Related-party transactions

Deals between the business and its owner, their family or their other companies may not be at market rates, and many will not survive the sale.
Category
Financials
Applies to
All business models
Severity
Price it in
Last updated
Author
Loupe editorial
Reviewer
Not yet reviewed

Why it matters

A related-party transaction is any arrangement between the business and someone close to it: the owner, their family, or another company they own or control. Common examples are rent paid to the owner for a building they own, sales to or purchases from the owner's other business, loans in either direction, and staff or costs shared between companies.

None of this is wrong in itself. The difficulty is that these arrangements are rarely set at market rates, and many will not survive the sale. Rent below market will rise when the owner starts charging you a full rent. A sister company that buys at generous prices may stop buying. Costs carried by another of the owner's companies will land on you. Each one changes the earnings you are paying for.

Here is a fictional example. Umberbrook Dental pays its owner R300,000 a year to rent the building it trades from. Similar premises nearby let for R600,000 a year. If the owner keeps the building and charges you market rent after the sale, annual profit falls by R300,000, and the value falls by that amount multiplied by whatever multiple you paid.

Loans need attention too. Money the owner has lent the company usually has to be repaid at or before completion. Money the company has lent the owner can sit on the balance sheet as an asset but may never be collected.

The usual response is to restate earnings on market terms, agree in writing which arrangements continue and on what terms, and ask for warranties in the sale agreement that every related-party arrangement has been disclosed. A lawyer can advise on how those warranties should be worded.

Warranties and indemnities

Warranties are the seller's statements of fact about a business in the purchase agreement; indemnities are promises to reimburse specific losses. Together they decide who bears risks that diligence could not rule out.

How to spot it

  • The notes to the accounts, where they exist, list related-party balances or transactions.
  • Rent, management fees or consulting fees are paid to names that match the owner or their family.
  • Customers or suppliers share an address, a director or a surname with the owner.
  • The balance sheet shows a director's or shareholder's loan account.
  • A supplier's prices are far better than anyone else's, or a customer pays well above the usual rate.
  • Staff are employed by another company but work in this one.

Questions to ask the seller

  • Does the business buy from, sell to, rent from, borrow from or lend to you, your family or any business you are connected with?
  • On what terms, and how do those terms compare with the market?
  • Which of these arrangements will continue after the sale, and on what terms?
  • Does another company, or do you personally, pay any of this business's costs, or does this business pay any of theirs?
  • What loans exist between you and the business, and how will they be settled at completion?

Documents to request

  • A schedule of all related-party transactions for the last three years, confirmed in writing by the seller
  • Leases, service agreements and loan agreements with related parties
  • Director's or shareholder's loan account statements
  • Company registry records for businesses connected to the owner
  • Evidence of market rent for any premises owned by the seller or their family
  • Customer and supplier lists, with any connections to the owner disclosed

Want this checked properly on a real listing?

A dossier checks the listing's figures, registrations and risks, with a source and confidence for every finding. Open a listing in the feed and request a dossier from its page.

Browse the feedWhat is in a dossier

Related red flags

  • Family or related staff paid off-market rates

    Relatives who work for little or nothing make profit look higher than it will be under a new owner, and pay for relatives who do little work is often presented as an add-back. Restate their pay at market rates before you apply a multiple.

    Severity: price it inOperations and people

  • Large or undocumented add-backs

    Add-backs raise the earnings a price is based on. When they are large, vague or unsupported, much of the asking price rests on claims rather than records.

    Severity: price it inFinancials

  • Margins far above industry norms

    Profit margins well above similar businesses can reflect a real advantage, but more often costs are missing, have been moved elsewhere or have not been paid yet.

    Severity: price it inFinancials

  • A lease ending soon or needing landlord consent

    For a business tied to its premises, a short lease or a landlord who must consent to the sale can put much of the value at risk. Read the lease early and make the landlord's agreement part of the deal.

    Severity: fixableLegal and compliance

  • One customer above 20% of revenue

    When one customer brings in more than a fifth of revenue, much of the value you are buying depends on a relationship you do not yet control.

    Severity: price it inCustomers and revenue

Guides

  • Add-backs: which hold up and which do not

    Add-backs turn the profit in the accounts into the earnings on a listing, and each one is paid for several times over in the price. This guide shows how to test them and which usually survive.

    9 minutes to read

  • Due diligence: what to check and in what order

    A sequence for due diligence that tests what could end the deal first, while it is still cheap to find out, and leaves the detailed and expensive work until the deal looks sound.

    10 minutes to read

  • SDE and EBITDA explained with worked examples

    SDE and adjusted EBITDA both restate a business's profit for a buyer, but they answer different questions. This guide builds each one up line by line for two fictional businesses and shows which to use.

    9 minutes to read

Checklists

  • Diligence document request list

    The documents to ask for once terms are agreed in principle, grouped by area so the seller can fill a data room in order and you can see what is still missing.

    About 30 minutes

  • Questions for the first seller call

    Questions to cover on a first call with a seller or their broker, grouped so the conversation stays natural and you still leave with the facts you need.

    About 45 minutes

Terms used

  • Normalised earnings

    Normalised earnings are profits restated to show what a business would earn in a typical year under a new owner, after removing one-off items and correcting costs that are not at market rates.

  • Add-backs

    Add-backs are costs added back to reported profit to show what a business would earn under a new owner. They raise SDE and adjusted EBITDA, so each one needs evidence.

  • Warranties and indemnities

    Warranties are the seller's statements of fact about a business in the purchase agreement; indemnities are promises to reimburse specific losses. Together they decide who bears risks that diligence could not rule out.

  • Disclosure letter

    A disclosure letter sets out the seller's exceptions to the warranties in a purchase agreement. Anything fairly disclosed in it generally cannot support a warranty claim later.

  • Completion accounts

    Completion accounts are a balance sheet drawn up at the date a sale completes, used to adjust the price for the actual cash, debt and working capital the buyer receives.

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