Why investors always need to watch out for related party transactions
This first appeared in Aimzine, an online publication for the AIM community
This month I had the pleasure of speaking at an event run by Cityzone which is a network for entrepreneurs, SMEs, investors and advisers. The event was part of their IPO Club which seeks to assist companies in considering their options and preparing for IPO. Introduced by the silky-tongued, boy-band sound-a-like, founder of Cityzone, Ronan Bryan, I gave a presentation which I’ve often given before at PLUS Markets seminars and also to entrepreneurs looking to raise Angel and VC funding; it’s a fairly versatile presentation because the issues it raises are common for companies seeking funding from whatever type of investor.
It seemed a good time to raise these issues because with the credit crunch firmly behind us companies are again looking at their options for growth funding and need to be aware of common gripes that potential investors raise. It is also a good time because one of the key issues the presentation raises is the matter of related-party transactions (RPTs) which have been in the news again (more on that later).
RPTs and shareholders
In private owner-managed companies it is not unusual for there to be RPTs. Of course, if there are no other shareholders it really doesn’t matter to anyone if the owner is running the business out of a property that he himself owns and is paying rent out of the company to himself. If there are other shareholders, then quite rightly they would expect to be told of such an arrangement to ensure that it is a normal commercial transaction at normal commercial rates and also to ensure that the owner cannot hold the company hostage at any time.
IFRS defines a related party as one which is related to the company preparing financial statements by way of joint control, management, ownership or significant influence.
When giving examples in my presentation I always presage the RPT section by saying that obviously these are old examples and of course no one would dream of having any such transactions in their company these days. It’s interesting at that point to see the looks on the faces of entrepreneurs. My co-presenters from the accounting firm BDO and the lawyers, Fasken Martineau, gave me wry smiles reiterating that infact such transactions are still commonplace in companies coming to IPO and even in many companies post-IPO. The point, of course, is that shareholders will put up with RPTs whilst things are good and the founder or CEO or director is critical to the business but soon become unforgiving about them when the business falters.
Such was the case a few years ago when Clarity Commerce Solutions, an AIM-quoted software company, was headed up by its founder Graham York. Amongst the various dubious activities going on in the company at the time was an expense of over £270,000 which had been incurred for the hire of an executive jet. Now we all know the hubris of CEOs having corporate jets, but this seems all the more bizarre for the fact that Clarity at that time only had revenues of around £20m. In this incident though, the facts were even more bizarre because the company which was providing the jet had as a director and principal shareholder none other than Graham York.
This was clearly an extreme and rather gratuitous example but this month a more subtle example of related party transactions was in the news again.
A company called Eco City Vehicles plc (“ECV”) gave an update at the beginning of November about some litigation involving Cabvision, an associate company in which ECV holds a 29% stake. ECV is not a party to the Cabvision litigation but it came to the attention of the non executive directors that KPM, a wholly-owned subsidiary of ECV had been making payments, totalling over £500,000, as loans to Cabvision in order to, amongst other things, fund Cabvision’s litigation. Whilst these payments were recorded correctly in ECV’s books they were not disclosed separately in the management accounts circulated to the board, and clearly hadn’t been approved by the board or any assessment undertaken as to whether they are reasonable.
The commercial logic of those loans would be questionable under normal circumstances but in this case, the picture was muddied by the fact that Cabvision is majority owned by relations of three directors of ECV. Fortunately, any loss to ECV’s shareholders would be covered by indemnities given by the directors of ECV when they undertook the reverse takeover that gave rise to ECV. However, that should not reduce the significance of these events and infact the lesson is that the facts behind related party transactions should never be overlooked.
Following a period when corporate governance has generally been improving, we should not lose sight of the fact that companies both on AIM and coming to AIM may have related party transactions. Many of these will be in the normal course of business and of no concern but you should always turn to note 93 (or wherever they’re tucked away) in annual reports to see if there are any related party transactions, and if the description doesn’t tell you all you need to know then it’s worth calling the company to find out more. The chances are that there may well be more to the transaction than meets the eye.