I was recently engaged to value a client’s interests in two businesses. These two businesses had several shareholders in common, and the businesses were doing business with each other. We refer to these as related parties and related party transactions.
Our client’s ownership percentages were different in each business, so we were concerned with whether transactions between the companies were priced at market, versus prices that unfairly benefit one or the other business. I investigated these transactions and adjusted them to market. Had I not done so, the value concluded for each business would have been different, thereby affecting the total value of our client’s holdings.
Some of the transactions between related parties that we frequently find and investigate for arm’s length terms include:
1. Lease rates for facilities and equipment owned by one party and used by the other
- Has the rent been at, above or below market value? Has rent followed a consistent pattern? Is there a valid lease? Are the terms and conditions similar to market, and are they being honored? Market rates must be determined through research.
2. Pricing on products sold by one company to the other
- Is transfer pricing at market value? If not, both party’s operating profits could be unfairly stated. Is there a contract between the companies detailing pricing terms? If pricing is non-market and no contract exists, a value analyst has difficulty forecasting future revenues and cost of goods.
3. Administrative, marketing and other fees paid by one company to the other for services provided
- Can the providing company document the services provided and amounts charged to the other party? When such documentation isn’t unavailable, the analyst must rely on management representations as to the validity of the fees. Is there a written agreement between the businesses detailing services and pricing? Absent documentation and guidance from the parties and without an agreement to rely on, the analyst is forced to assume that such fees have been, and will be, calculated accurately, fairly and consistently.
4. Fees for intellectual property licensed by one company to the other related company
- Common examples of licensed IP are trademarks, software and product designs.
5. Receivables/payables and loans to/from related parties
- Loans to related parties may be reclassified as non-operating assets. Loans from affiliates may need to be reclassified as long-term debt, or equity if there is little chance that such loans will be repaid. Related party receivables may need to be discounted to market value or eliminated, depending on their economic substance.
In each of the above cases, market rates are determined either by observing prices between the business and unrelated suppliers and customers, or by finding market data for pricing of similar property or services between unrelated parties.
In the case of our client, after studying the related-party transactions, I normalized the financial statements to arrive at market-based controlling interest cash flows, to determine equity values on an operating basis. Once values were determined for each enterprise, I adjusted to the level of value of our client’s minority interests using appropriate discounts for lack of control and marketability.
Related party transactions exist in many family-owned and closely-held businesses,and their affect on value needs to be considered and handled according to the intended use and circumstances of the valuation. Feel free to call us if we can provide additional information or help with a current business valuation need.