The related party note at the back of a private energy company's audit lists arrangements the independent directors should price and vote on every year

The paragraph sits on page nineteen of the audited statements, under a heading most readers skip. “The Company leases its operating yard and shop from an entity controlled by its majority shareholder and paid rent of $480,000 under that lease during the year. The Company also purchased hauling services of $1.1 million from a business owned by members of the shareholder’s family.”

Two sentences, two figures, no commentary. The auditor wrote them because the accounting rules require it, and in most board rooms I have sat in, nobody reads them aloud.

I read them aloud. In a privately held oilfield service company, that note is the one place in the financial statements where the owner’s other interests meet the company’s money in writing, and it tends to describe the most durable contracts the company has. A customer can cancel a service agreement on thirty days’ notice. The lease on the yard where every truck parks at night was signed by one man sitting on both sides of the table, and it will outlast most of the customers.

Here is the position I hold, and a good director could argue with it. When outside capital arrives, I do not ask the owner to unwind his related party arrangements. I ask that each one be written down, priced against the market once a year, and approved by the directors who have no interest in it. A fairly priced lease from the founder is frequently the best lease the company has. He will not sell the yard out from under the business, he will wait a month on rent in a bad quarter, and he wants the tenant to survive more than any stranger would.

The opposing view deserves its full weight. Many investors I respect want every one of these arrangements gone by closing, on the theory that nobody can govern a company cleanly while its largest shareholder is also its landlord and its vendor. They are right that the conflict never goes away. My answer is that a conflict disclosed and voted on every year is easier to govern than a forced move to a worse yard under a stranger’s lease, undertaken mainly so that page nineteen looks tidy.

The three decisions the note quietly shapes

Mechanically, the note is narrow. The auditor lists transactions with parties who can control or significantly influence the company: owners, directors, officers, their families, and the businesses those people own. It gives the nature of the relationship, the amount for the year, and any balance still owed at year end. It says nothing about whether the price was fair. Auditors are careful on that point, and they should be, because they have no way to know.

That silence is the whole problem. The figure in the note is a fact. Whether $480,000 is the right rent for four acres, a shop with two overhead cranes and a wash bay on a county road in the Permian Basin is a judgment, and nobody on the audit engagement is paid to make it.

So the note shapes three decisions, usually without anyone noticing that it has.

The first is the renewal. A related party lease tends to roll forward on its old terms because nobody wants to open that conversation. Rent set in a strong year stays at that level through a weak one. Or rent set low as a favor a decade ago stays low while every property around it doubles. Either way, the reported margin carries a number that no one negotiated.

The second is the sale. Every buyer I have dealt with reads this note early, because it tells him which costs will move the day the founder stops being both landlord and owner. If the rent sits below market, the buyer adds the difference back to cost and the earnings he is pricing shrink. If it sits above market, the owner has been taking cash out through the lease, and the buyer will want that explained before he discusses anything else.

The third is quieter. A hauling contract with a family business sets a standard for every other vendor. When the related hauler is paid in fifteen days and everyone else waits sixty, the dispatcher knows it, the other haulers know it, and the controller who signs the checks knows it best of all. The note gives the annual total. It never shows the payment terms, and the payment terms are where a company tells its own people what the rules really are.

Where the note misleads

The note describes only what the auditor was told about. A related arrangement that runs through a friend, a former partner, or a company held through a trust with an unfamiliar name may never reach page nineteen, and in my experience the omissions are rarely deliberate. An owner who has bought valves from the same supply house for twenty years may simply not think of his college roommate’s stake in it as a relationship worth mentioning.

The note also treats every arrangement as the same kind of thing. A yard lease at a fair rent and a consulting fee paid to a nephew for work nobody can describe appear in one paragraph, in one flat voice, with only a dollar figure to tell them apart. A director who reads the note once and moves on will treat them alike. They deserve very different conversations.

So the way I work is simple and slightly tedious. Once a year, before the budget meeting, management brings the board a single page listing every related arrangement it knows about, with one column for the price paid and another for what the same thing would cost from a stranger. The second column needs support better than an opinion: an appraiser’s letter on the rent, two outside quotes on the hauling. The owner leaves the room. The directors who remain approve, reprice, or set an end date for each line, and the minutes record which. Then the owner comes back in and the meeting moves on.

Most years that takes twenty minutes, and most of its value lies in everyone at the company knowing the review happens.

The weak spot is the second column. A fair price for a yard in a small basin town is often unknowable. There may be three comparable properties within fifty miles, one owned by a competitor and one by the founder’s cousin. An appraiser will produce a number, and I have learned to treat it as the start of an argument rather than an answer. When the market is that thin, the annual vote can turn into a ritual that blesses whatever the owner proposed, and I do not have a clean fix for that. Sometimes the honest entry in the minutes is that the board could not establish a market price and approved the lease for one more year anyway.

I have also been wrong in the other direction. Years ago I pressed an owner to move his hauling from a family business to a larger outside carrier, on the grounds that the related contract made the company harder to govern. The outside carrier was cheaper on paper and slower in fact. Nobody there answered the phone on a Sunday night when a customer needed fluids hauled off a location ahead of a Monday rig move, and the family business always had. The company moved the work back within the year. What I misjudged was what the price had been buying. The related vendor was selling reliability on terms no stranger would match, and my comparison had no column for it.

That experience is why I ask for the vote rather than the unwind. A board that looks at these arrangements every year, with the conflicted party outside the door, keeps the good ones and ends the bad ones on its own schedule. The alternative is a buyer or a lender deciding for it at the worst possible moment.

The paragraph on page nineteen will be there next year in the same flat voice, and the year after that. No board can make it say more. What a board can do is make sure that every figure in it was looked at by someone with nothing to gain from the answer, which is the only kind of fairness anyone outside the room will ever believe.