The situation
A second generation textile family in Surat runs a weaving unit, a processing unit and a trading company, each a separate company with the same family as shareholders. The processing unit, which they plan to sell, buys grey fabric from the weaving unit, sells part of its output through the trading company, and pays rent for its building to a family member. A buyer's CA asks for every transaction between these entities for three years.
Why buyers care
Related party transactions are dealings between the company and people or businesses connected to its owners or managers. They are common and often perfectly sensible. Buyers care for three reasons:
- Profit may not be at market rates. If the processing unit buys fabric cheaply from the family's weaving unit, its profit is higher than it would be with an outside supplier.
- The arrangement may stop after the sale. The family may have no reason to keep giving favourable terms once they no longer own the business.
- Compliance. Company law in India sets approval and disclosure requirements for related party transactions. Gaps can become warranty issues.
What diligence will ask for
- A list of related parties and how they are connected
- Every transaction with each, by year: purchases, sales, rent, loans, guarantees, salaries
- The approvals and disclosures made for them
- Contracts, if any, and their terms
- A view on whether the prices are at arm's length
Putting them in order before a sale
Decide which will continue
Some arrangements should continue after the sale, such as a supply contract the buyer values. Put those into written contracts at market terms, with a reasonable notice period.
End or unwind the rest
Loans to family members, guarantees for family companies and informal arrangements are better ended before the sale, with the help of your CA.
Fix the profit view
If past transactions were not at market rates, prepare a schedule showing what profit would have been at market terms. A buyer will do this anyway; doing it first keeps the discussion grounded.
Check approvals
Ask your CA and company secretary to confirm that the approvals and disclosures required at the time were made. Where something was missed, take advice on how to regularise it.
A short checklist
- Related party list confirmed with your CA
- Three year schedule of transactions
- Continuing arrangements written up at market terms
- Loans and guarantees to related parties cleared
- Approvals and disclosures checked
Where Synerger fits
In the Synerger data room, related party schedules sit in the financial folder and the buyer's questions about them are tracked to an answer. See also quality of earnings and management buyouts and family succession.
General information; confirm company law requirements with your company secretary or lawyer.