Related Party Transactions-Things To Look At While Investing In Such Companies

6 mins read
by Angel One

Through our different blogs we guide our investors to focus more on qualitative parameters as compared to the quantitative parameters. And one parameter to analyze in detail in this regard is – related party transactions and related party deals promoters are entering into. There are few examples where promoters and companies get into few transactions that look simple but one needs to check it in detail.

Just to list down a few examples of related party transactions – as an analyst we should look at the different transactions like Lending transactions between company and promoters where the promoters take loan from Company or company takes loan from promoters. There are other transactions or events like company buying or purchasing assets from promoters. Other examples are promoters running a competitive business as a different entity or even providing consultancy to their own company. Let’s understand related party transactions detail.

While investing please remember, company and promoters are two different entities. Company is a different legal going concern or an entity. So never confuse company with promoters. Companies and promoters are completely different entities. Just that the promoters are running the show as per the Company Act. Still as a person running the show and being a different entity – They are related parties. Hence if the company and promoters are doing business with each other – it must be checked thoroughly.

The first parameter on the check list (for related party transactions) of investors should be lending transactions between the company and the promoters. Even it has got some sub Categories. Like the first would be – If a company gives loans to the promoters.

Loans given to promoters written-off

It is a normal process when an employee gets a loan from his company. And similarly many times, companies give loans to promoters as well. However the issue arises when such loans are then written off later. It indicates that the company cannot recover the money from the promoters. It effectively means that the company has given free money to the promoters. This clearly indicates the fact that Promoters themselves approved the money lending to use it and never repay. With minority shareholders not having a say in this – this is a negative aspect on the part of promoter quality. A simple loan given to the promoters is one kind of related party transaction.

Interest free or cheaper interest loans provided to promoters

While in the above case the loan given to the promoters is written-off, in some cases there are cheaper interest loans or interest free loans are given to the promoters. In simple terms it means that the promoters enjoy cheap money in their personal ventures whereas the minority shareholders bear the cost of the funds especially if the company has taken loans from banks to give the money to promoters. Another kind of related party transaction. In our few previous blogs we had categorically mentioned that capital allocation in business is what decides the growth trajectory of that company. If capital is being provided to promoters for personal use at the cost of suffering to retail shareholders then the capital allocation is wrong. So such interest free or further cheaper loans given to the promoters should be seen with a close scrutiny.

Promoters giving loans to company at higher interest rates

While in the above two cases promoters benefited from getting cheaper access to funds at the cost of other shareholders, there is another way round as well. Many times, companies take loans from the promoters; however, they pay a high-interest rate to the promoters for these loans, which is higher than the cost at which the company can take money from the banks. As a result, the promoters gain at the cost of minority shareholders of the company. They would be showing it as a help to the company as when the company required funds and had no other way to raise funds. Such an act should be scrutinized closely. If the business is doing well such a scenario (no access to funds) would not have been there. Further if there is no cash flow generation anyway it should be on your investment list. Simple way helping promoter by the way of related party transactions.

Assets being sold between company and promoters – at higher or lower cost

There are instances when companies buy assets or other business from promoters at a high price. This means the company is paying more than what it should have actually paid as an intrinsic value. It represents a situation where the promoters get a higher price by selling their assets to the company than what they would generally get from the market. In such cases, ultimately, the minority shareholders pay the price. In simple terms, this kind of capital allocation is completely going wrong just to benefit few from the promoters group.

There are other examples or cases where the promoters enter into a joint venture (JV) with the company to start a new business and later when the business fails, then the company buys the stake of the promoters to bail them out. In such cases, ultimately, the minority shareholders bail out the promoters. There are few cases where such cases have occurred especially in infrastructure companies and few realty companies.

There was an example when the company had taken office premises and other facilities on rent from promoters. The rent paid was much higher than the actual prevailing rates. So promoters stand benefited through such related party transactions.

On other occasions, the company invests and provides seed capital to the promoters to help them start their personal ventures. It is effectively the minority shareholders funding the personal ventures of the promoters.  Like in the recent case Zomato had started to invest in new ventures through the funds raised through IPOs.

Assets sold to the promoters at lower than market price

In this case, the promoters first make the company buy an asset from the market, and then, in turn, they purchase it from the company at a lower price. Many times, the companies create assets or businesses by investing money and resources, and then promoters buy it at a cheap price from the company. There are examples where the company buys an asset and promotes enjoying those assets for free. In all the above cases, the minority shareholders end up bearing the cost for the promoters’ gains.

Companies enter into sale and purchase and consulting transactions with promoters

In this case, it is the promoters who decide how much business or how much profit margin they will leave for the listed company and how much profit margin they will keep for themselves. In almost all such cases, the listed company and the minority shareholders are at the mercy of the promoters.

Promoters running a competing business in their personal capacity

While it is not illegal to run a business competing with the company, the promoters are at advantage here. They own this business and the competitive business as well. Such promoters are at an Advantage of Where to put the business they have garnered from a particular set of customers.  In such cases the company stands at disadvantage as promoters would divert more business to their own company than the one where there are many minority shareholders. Such business at personal capacity is beneficial to promoters and would be termed as a related party transaction.

Company standing as guarantees to lenders on behalf of promoter

In such situations, it may seem that the listed company has not entered into any monetary transaction with the promoters. However, the guarantee given by the listed company ensures that the promoters enjoy the fruits of their personal business until the time it runs successfully. If the personal business of the promoter fails and any liability arises the company would have to pay up as it stood as a guarantee. Here the minority shareholders are at a loss.

All in all, the related party transactions are to be watched with a close eye.