Related party transactions are not automatically a problem. A group that buys components from its own supplier, or leases a workshop from its founder, can be running an entirely sensible business.
The problem is timing. The arrangement exists because of a relationship the seller holds. At closing that relationship does not transfer — the business does. So the question for a buyer is not "is this related party transaction improper", but "at what terms would this transaction be available to me?"
Four tests for each significant counterparty
| Test | The question it answers |
|---|---|
| Pricing | Is the price consistent with what unrelated parties pay or receive for comparable terms? |
| Substance | Does the counterparty have independent operations — its own people, premises, and revenue from other customers? |
| Survival | If the founder were no longer involved, would this counterparty transact on the same terms? |
| Substitutability | Could this volume be placed with an unrelated party at similar margin, and how long would that take? |
Applying the tests in practice
Pricing is tested by comparison, not by assertion. Take the same product sold to a related customer and to an unrelated one in the same period, and compare the net realised price after rebates. Where no comparable exists, compare the gross margin on the transaction with the company's overall margin on similar products. A counterparty sitting well outside the range needs an explanation.
Substance is tested by looking for the things a real business has: employees on its own payroll, premises it occupies, and customers other than the target. An entity with no independent employees that exists to buy from one company and sell to another has to be treated as part of the group's distribution, not as a market customer.
Survival is the test that decides valuation treatment. Where the answer is no, the related revenue generally belongs outside the maintainable earnings base entirely rather than at a discount. Discounting accepts that the revenue is real but reduced; excluding it accepts what the buyer will actually own.
Substitutability sets the cost of replacement. Even where related volume can be replaced, the replacement carries transition cost, margin change, and time. That cost belongs in the price, quantified rather than assumed.
Where related party exposure sits
Buyers tend to look at revenue first, but the exposure is broader:
- Purchases. A favourable supply arrangement that depends on the founder is a cost that rises after closing, not a competitive advantage.
- Property and equipment. Premises leased from the founder or from a family holding company, often below market rent. Post-closing rent is a recurring cost, and the lease has to be renegotiated or replaced.
- Shared services. Finance, HR or IT provided by an affiliate, sometimes without a charge and sometimes at a rate that will not survive the group separation.
- Funding and guarantees. Loans between affiliates, and guarantees given for related parties. These show up in cash flow and in contingent liabilities rather than in operating profit.
- Fund flows. Balances in other receivables and other payables that arise from transactions between the owner and the company rather than from trading.
Not every related party transaction is a deduction
It is worth saying the opposite case explicitly, because it improves the quality of the analysis: some related party arrangements reduce cost genuinely and would continue under a new owner because they are commercial rather than personal. A group buying office that charges a below-market service fee, where the arrangement is contractual and the group continues to exist, may be sustainable. The test is the same four questions — applied without assuming the answer.
What to request
- The full related party register, as maintained by management
- A shareholder and group structure chart, to the individual owners
- Contracts with related parties, in original rather than summary form
- Lease agreements for premises used by the business
- Details of loans, guarantees and balances with affiliates
- The cash book or bank statements showing transfers between the owner and the company
The structure chart should reach the individual owners. Where it stops at holding companies, the missing layers are a question for management rather than a conclusion to draw.
Common questions
Are related party transactions a red flag in a China acquisition?
Not automatically. Related party arrangements can be entirely legitimate and commercially efficient. The issue is transferability: they exist because of a relationship the seller holds, and a buyer has to establish whether the same terms would be available to a new owner.
How are related parties identified in a China due diligence?
By starting from the shareholder and group structure chart, reaching the individual owners, then reconciling the resulting list against transaction ledgers and public corporate registries. Management's own register is the starting point, not the conclusion.
Should related party revenue be excluded from maintainable earnings?
Where the arrangement depends on a relationship the seller holds rather than on the business itself, excluding it is usually more accurate than discounting it. A discount assumes the revenue is real but reduced; exclusion reflects what the buyer will actually own.
This article describes a general approach. It is not accounting, tax, or legal advice for a specific transaction. Views are my own and do not represent any firm.