Keeping it in the family

Why investors always need to watch out for related party transactions


This first appeared in Aimzine, an online publication for the AIM community www.aimzine.co.uk 


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.


Clarity example


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.
   
Recent example


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.

Quote of the year - strong contender

Can a fund manager really be this ridiculous?

Well, the year is nearly over and there have been some good quotes bandied around this year but a latecomer has appeared courtesy of an anonymous fund manager.

Now, we know that fund managers are always being ridiculed by the press. Commentators accuse them of having a herd mentality by following each other into certain shares for fear of being left out of the “next big thing”. Others accuse them of actually destroying the value of investors by their poor selection of shares and making things worse by creaming off a few percent of the funds every year for themselves, whether the fund has a good year or bad year.

Perhaps, we should lay off the attacks because on the basis of this contender for quote of the year, some of them appear to be able to ridicule themselves without our support.

During the last 12 months there have been very few companies coming to IPO and the main reason for this has been that fund managers have been nervous about valuations of companies coming to market and haven’t wanted to invest their surplus cash. So, no fund manager support, no IPO for the company. “Simples” as a meerkat would say. Well, not if you’re this particular fund manager, who said;

“There are serious questions to be asked, [such as] why a company which was so reliant on just two people was allowed to list in the first place.”

The answer to this “serious question” is because fund managers (like the contributor of this quote who is a large shareholder) supported it, despite the fact that the risk factors section in the IPO document specifically mentioned the reliance on two employees.

The irony of all this, as the price has fallen from 220p at IPO last December to 115p today, is that the company he is referring to is Gartmore, a well known errr…. fund manager. Ouch!

Play the game - profits aren't everything

Why you need a balanced management team which doesn’t agree about everything

It may come as a surprise to you that a Finance Director should be saying that profits aren’t everything.

It may make more sense if I tell you that I am a supporter of Arsenal Football Club. So for shareholders the recent announcement by Arsenal of a profit of £56m in the last year is good news. For fans however whilst it’s nice to know that we can crow at the financial imprudence of other teams and their owners, at the end of the day this profit isn’t the ultimate measure of a football club.

In a corporate world where other metrics are increasingly the norm whether they relate to corporate and social responsibility, or health and safety, or corporate governance, our ultimate measure has to be winning leagues and cups and on that measure Arsenal have fallen short for the last five seasons. Although we have a manager who has brought trophies home during his 14 year tenure, many fans are beginning to question his current approach.

What’s this got to do with a balanced management team?

Well, the problem seems to be that the manager, Arsene Wenger, is behaving like a CEO when infact he is not the CEO. As manager of the team, his responsibilities are wider than just the team but what fans want is for him to fight his corner to build the best team to win trophies. Instead, what we have is someone who prefers to talk about the club paying down debt on its stadium move a few years ago and his prudence in not overpaying for players. Despite having an  MSc in Economics what he should be doing is having heated debates with the CEO about why he needs to pay, say, £10m for a new goalkeeper.  

In any organisation, all members of the management team, should share in the overall goals of the business but they should also fight their corner for their areas; businesses need that competitive tension. With Arsenal, it is almost as if you have an Operations Director who won’t ask for more delivery capability to improve results which will ultimately lead to increased or better sustained profits. The danger becomes that the short term profitability generated today means that, after many years trophy-less, future profits (in the form of ticket sales and sponsorships etc.) are jeopardised.

Although Mr Wenger makes a big deal of all the good young talent he has nurtured, if the clubs continues to fail in winning anything then that talent could well move on to other clubs. That will probably be a profitable sideline but the core business is surely that the team that wins trophies; not acting as an academy for other clubs. That is surely not in the long term interests of fans or shareholders. 

And as a Finance Director, I like short term profit but I prefer long-term sustainable profits.