For many reasons, it’s not unusual for startup and growing ventures to conduct business with related parties. These include board members and key employees, organizations they influence or control, and their close family. Relevant ties may involve transactions within and outside the normal course of trade and comprise compensation packages, sales and purchases of goods, borrowing and lending money, rentals, and professional services.
Through these relationships and arrangements, startup and growing ventures garner access to expertise, assets, and financial help not otherwise available to an organization with limited resources or performance records. However, transactions with related parties also carry real and perceived risks separate from similar dealings conducted with unrelated parties. By following certain practices, organizations may enjoy the benefit of these activities while managing the exposures.
Key Risks of Related Party Transactions
Because one party has the potential to influence or control both sides of a transaction, arrangements between related parties may have terms inconsistent with those between unrelated parties. This self-dealing leads to three types of risk.
First, these transactions carry a greater danger of asset misappropriation, where the related party achieves financial or personal gain to the detriment of the organization. Such fraudulent activity often arises through compensation being paid at above-market rates or the transfer of funds occurring without an exchange of goods or services.
Second, because of the ability to structure agreements in a manner that disguises their economic substance, there is a greater risk of misrepresentation with related party dealings. The outcome of a distortion may include achieving a financial target such as recording revenue or understating expenses, overvaluing an asset, or hiding an obligation, such as a guarantee or commitment.
Third, these activities attract extra scrutiny from regulators and external stakeholders. Outsiders often start with a presumption that related party transactions are disadvantageous to the enterprise. Even in legitimate transactions, defending against this additional examination may require substantial financial cost and affect an organization’s reputation in the public eye.
Practices That Mitigate Risk
The outright prohibition of business with related parties is not always practical, effective, or in an organization’s best interest. Instead, there are three categories of practices that can reduce exposure while allowing for the potential benefits of conducting these activities.
First, the board of directors should approve related party agreements in advance, and approval should not be a perfunctory exercise. To serve as an effective check, board members should consider how outsiders will view the arrangement. Further, any directors involved in a transaction should recuse themselves from its approval.
Second, strong financial controls prevent unauthorized deals and ensure transactions conform to board guidelines. Failing to have these procedures can nullify an otherwise effective board review. Beyond normal protocols, two additional processes are important for addressing related parties: a mechanism for making a comprehensive identification of those parties and a means to identify transactions with them in the company’s accounting system.
The most direct starting point for identifying related parties is to have board members and key personnel identify any business interests where they exercise control or significant influence. This can involve an annual disclosure form and an understanding that these individuals will disclose changes in a timely manner. The comprehensive list of related parties produced from the first process informs the second, which is flagging pertinent activity within the accounting system. This process is best performed when setting up a new customer, vendor, or employee relationship within the accounting package.
The final category of suggestions relates to the transparent disclosure and reporting of the impact of those transactions. In establishing charts of accounts, companies should consider separate ledger accounts for related party activities. This disaggregation at the transaction level simplifies the efforts of reporting these transactions on the financial statements and footnotes, and also facilitates complying with regulatory disclosure requirements.