I am often asked if related party transactions should be taken into account when analysing a business or an entity, for the purposes of undertaking a valuation or the assessment of economic loss. That is, should they be included, excluded or adjusted to some other amount?
The first step in determining how to treat related party transactions is recognising the purpose of the engagement and analysis being undertaken. If it is to:
- Value a business, then you need to ascertain what that business would be worth based on arms-length transactions being undertaken by the related parties (i.e. as if the dealings were between independent, unrelated, and well informed parties who have no interest in the transactions consequences to the other party);
- Value a company or a trust, this incorporates the business value as discussed above, along with the value of the other assets and liabilities of the company or trust; or
- Assess economic loss then you need to consider the effect of the loss causing event, which may or may not be impacted by related party transactions.
Accordingly, the occurrence of related party transactions will affect the above assessments differently.
Say we have a company owned by Mr G. that operates a printing business from a factory. Further analysis of this company and the business it operates reveals the following related party transactions:
- Mr G. pays himself above market rates, as the business is very profitable;
- Mrs G. undertakes bookkeeping and other administration each week, but isn’t paid a wage;
- The factory is owned by Mr G.’s Family Trust;
- A management fee is paid to Mr G.’s brother, who does not work in the business or provide any goods or services;
- A related company (ABC Pty Ltd, also owned by Mr G.) owes money to this company (i.e. a receivable loan); and
- This company owns shares in ABC Pty Ltd (i.e. an investment), which it purchased for $2.
These related party transactions may distort the true performance of the business and the true position of the company.
Valuations – Company / Trust / Business
The valuation of a company or trust will incorporate the value of the business it operates (along with its other assets and liabilities). However, a business is valued stand-alone of any entity it may form a part of.
In valuing the printing business, each of the related party transactions needs to be adjusted to reflect an arms-length / commercial arrangement, so the true performance of the business can be established.
Based on the example set out above, the following considerations would determine the required adjustments for the related party transactions, to value the business and the company:
- What is the commercial value of the roles performed by Mr and Mrs G.? How much would an unrelated party be paid to undertake these duties?
- Is the rent paid on the factory at market rates? How much would be paid if the factory was owned by an unrelated party?
- The ‘management fee’ is not a true expense of operating the business, and appears to be a personal arrangement whereby Mr G. is providing the company’s funds to a related party? The effect of the payment of ‘management fees’ reduces the profits of the business. This payment is actually a loan of the company’s funds – which should be captured on the balance sheet;
- Whether the related party loan will actually be collected. That is, does the related party have the financial capacity to repay this loan?; and
- What is the value of the investment in ABC Pty Ltd? This may differ from its initial cost. A valuation of that company would be required.
Appropriate financial analysis and understanding what is ‘behind the numbers’ is vital in reaching the correct conclusions, as each business or entity’s circumstances will be unique, and should be considered as such.
Part 2 of this article (next week) will consider related party transactions in the context of assessing economic loss.
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