Entry: Arms-Length Transaction
Pronunciation: armz - lengkth - trans - ack - shun
Definition: a transaction where the parties involved act independently and are otherwise unrelated to each other
Arm’s-length transactions occur all the time in contract situations, business, real estate, securities, and many other types of transactions. An arm’s-length transaction occurs when 2 or more parties involved in the transaction act in their own best self-interests. In other words, neither party (or parties) has a relationship which each other that alters the way in which the transaction would be conducted with someone else.
So, if the parties in the transaction have some type of relationship with each other, the transaction might not be considered an arm’s-length transaction. For example, if Dad sells his car to his son, rather than a stranger, it likely will not be considered an arm’s-length transaction. That’s because Dad is more likely to give his son a better deal on the car than the stranger because of their father-son relationship. Let’s go over another brief example in the sale of business to even better illustrate how this operates.
Arm’s-Length Transaction – Example
Assume that Son wants to sell a painting business that he recently bought from his Dad. So, Son hires a business valuation expert to value the painting business. The business valuator first looks to see what Son paid for the business from Dad. The business valuator finds out that Son paid Dad $500,000 for the business. Then, the business valuator looks at the numbers of the business.
The business valuator learns that Son employs 10 employees and the painting business makes around $1.5 million dollars in gross sales per year. The painting business has a very good reputation in the local community and a steady stream of clients.
With all that background information, the business valuator determines that Dad did not sell the business to Son in an arm’s-length transaction. Rather, Dad sold the business to Son at a great discount. If Dad had sold the business in an arm’s-length transaction, Dad likely could have received about $2 to $3 million for the business. So, the business valuator gives Son a valuation on the business which is much higher than $500,000 – the price that Son paid for the business to Dad.
Through this simple example you can see that transactions – especially in the sale of businesses – must be evaluated on all the different aspects of a transaction, including whether any arm’s length transactions occurred.
Transactions which are more scrutinized for possibly not being arm’s-length transactions, include transactions between family members, parent and subsidiary companies (e.g. a company at least partially owned by the parent company), etc. In other words, you must look at whether there are any conflicts of interest between the parties involved in the transaction.
Family members, parent and subsidiary companies, and others with potential conflicts of interest, can still create arm’s-length transactions. However, these types of parties need to show that the transaction was conducted the same as it would have been with a stranger. One way to do this is to hire an independent appraiser or business valuator to value the transaction, and then use the value created by the appraiser or business valuator.