Loans between a target and its owners, directors or sister companies quietly distort the net debt bridge. Here's how to classify related-party balances like a seasoned FDD analyst.
An owner draws £40k of salary against a market rate of £120k, tells the accountant to book the shortfall as a "loan to the company," and three years later that balance sits at £240k on the trial balance under "director's loan account." Is it debt? Is it deferred pay? Is it equity in disguise? The honest answer is that nobody in the building has thought about it since the day it was booked — and now you, the FDD analyst, have to decide whether it belongs in the price. This is the world of related-party loans, and it is where owner-managed deals quietly go wrong.
Family and founder-led businesses make up a large share of the mid-market transactions you will work on, and almost all of them carry financial arrangements with owners, directors or affiliated entities that never went through an arm's-length commercial process. These balances need a sharper lens than the standard debt-like items checklist, because their true economic substance is routinely disguised by how they were first documented — or, more often, by the fact that they were never properly documented at all.
A related-party loan can hide almost anywhere on the balance sheet. It might appear as "other payables," "director loans," "amounts due to group undertakings," "loans from connected parties," or simply be buried inside a larger accruals line. It rarely gets a clean, clearly labelled row of its own. Unlike a bank facility with a tidy loan agreement, an arrangement fee and a repayment schedule, these balances frequently have no formal terms at all — or terms drafted retrospectively to formalise what was really an informal cash movement between the owner and the business.
That opacity is exactly why they matter. In a well-run net debt bridge, every line should be traceable to a document and an economic rationale. Related-party items resist that discipline. They demand that you reconstruct intent from behaviour: who put money in, when, why, and what everyone assumes happens to it on completion.
A related-party balance is rarely a documentation problem. It is an economic-substance problem wearing a documentation costume. Your job is to strip the costume off.
The starting question is deceptively simple, and the answer almost never is: would this balance survive a sale to an unrelated third party, or does it exist purely because of common ownership and therefore disappear when that ownership changes?
Work through the three archetypes you will meet again and again:
Getting this classification right is not academic. It moves cash between buyer and seller, and it is precisely the kind of judgement that sits at the heart of the equity value bridge.
Suppose you are diligencing a founder-led distribution business. The trial balance shows three related-party items lumped, unhelpfully, into a single £610k "amounts due to connected parties" line. You unpick them:
| Balance | Amount | Interest charged? | Documentation | Economic substance | Net debt treatment |
|---|---|---|---|---|---|
| Owner acquisition loan | £350k | Yes, 6% p.a., paid | Signed facility, 2022 | Genuine financing | Debt-like — include in net debt |
| Under-drawn salary "loan" | £180k | None | None | Deferred remuneration | Normalise EBITDA, not net debt |
| Loan to sister company | £80k (receivable) | None | Verbal only | Intra-group funding | Exclude — settled pre-completion |
The mechanical impact is stark. If you had swept the entire £610k into net debt as a payable, you would have overstated the deduction from equity value by £260k and completely missed an EBITDA adjustment worth normalising. Line by line:
| Treatment error | Consequence for the buyer |
|---|---|
| Salary "loan" left in net debt | £180k over-deducted; true recurring staff cost hidden |
| Salary "loan" ignored entirely | EBITDA overstated by the annual under-drawn amount |
| Sister-company receivable netted in | Phantom £80k asset that vanishes at completion |
The £180k under-drawn balance carries a double sting: it should come out of net debt and its annual run-rate should be added to the cost base as a normalisation. Miss both and your EBITDA and your bridge are wrong in the same direction.
A credible related-party review goes well beyond reading the balance-sheet caption. In practice you:
Sellers frequently assume these balances simply vanish at close without any price adjustment. That assumption is exactly the sort of thing a good analyst surfaces early — before it hardens into a last-minute SPA dispute over who bears the £350k.
There is also a tax dimension that is easy to overlook and expensive to ignore. Interest-free or below-market related-party loans can trigger transfer-pricing and imputed-interest questions, and a director's loan account that has been overdrawn — the company effectively lending money to the owner rather than the other way round — can carry its own tax charges and reliefs depending on jurisdiction and timing. You are not the tax specialist, and you should not pretend to be, but you are the person who first spots the balance and flags it into the tax workstream. A related-party loan that looks clean in net-debt terms can still hide a tax liability that belongs somewhere in the equity value bridge, and the FDD analyst who connects the two workstreams rather than treating them as separate silos is the one who stops a nasty surprise emerging after signing.
Classification is not the end of the story; it dictates mechanics. A genuine owner loan destined for repayment at completion usually gets caught by the net debt sweep and settled from proceeds — clean, provided everyone agrees it is debt. A balance you have reclassified as deferred remuneration needs to flow through your normalised working capital and EBITDA analysis instead, and may prompt a conversation about the going-forward cost of paying the owner-manager a market salary post-deal.
Under a locked-box mechanism, the treatment must be nailed down at the locked-box date and protected by leakage covenants — you do not want the owner quietly repaying themselves the £350k between locked-box and completion. Under completion accounts, the balance flows through the true-up, which buys time but also invites dispute if the definition of "net debt" in the SPA is loose about connected-party items. Either way, the FDD report needs to state the treatment explicitly rather than leave the lawyers to infer it.
In an institutionally owned business, related-party balances are rare and, when they exist, usually well-documented and arm's-length. In a founder-led or family business they are common, informal, and frequently the single largest undocumented item in the entire net debt bridge. The same informality that produces contingent liabilities and off-book arrangements produces these loans, and it produces them at scale.
Treating a £350k director's loan with the same rigour you would apply to a syndicated bank facility — rather than as a footnote to be cleared in the final week — is one of the clearest signals that separates a thorough FDD analyst from someone mechanically ticking a checklist. It is also a recurring theme in the wider catalogue of red flags in FDD: the risk is not that the number is large, but that nobody has decided what it is.
The reason these balances reward disproportionate attention is that they sit at the intersection of three workstreams that busy deal teams tend to run separately — net debt, working capital and management remuneration — and they fall through the gaps precisely because no single workstream owns them. A bank loan is unambiguously the net-debt analyst's problem. A related-party balance might be net debt, might be a remuneration normalisation, might be an equity contribution, and might have a tax tail. Someone has to take ownership of deciding, and in a well-run engagement that someone is you. The habit to build is simple: whenever you see a connected-party caption, treat it as unclassified until you have positively decided what it is, rather than defaulting it into whichever bucket the trial balance happened to file it under. That single discipline catches most of the value that gets lost on owner-managed deals.
Expect this to come up as a scenario, because it separates candidates who understand substance over form from those who have only memorised a debt-like items list.
Interviewer: "A target has a £240k director's loan on its balance sheet. How do you treat it in the net debt bridge?"
"My first instinct is not to treat it at all until I understand what it actually is, because 'director's loan' tells me the label, not the substance. I'd want three things: any loan documentation and its date, the interest history — has interest been charged and paid, or just accrued — and the movement over the last three years. If it's a properly documented loan the owner made to fund the business, with real terms, I'd treat it as debt-like and include it in net debt, flagging that it needs repaying or refinancing at completion. But if it turns out the balance built up because the owner was under-drawing salary and booking the shortfall as a loan, that's not really financing — it's deferred remuneration. In that case I'd pull it out of net debt and instead reflect the true cost of the owner's role as an EBITDA normalisation, because otherwise I'd be overstating maintainable earnings. The worst outcome is treating it as debt when it's actually deferred pay: I'd over-deduct from equity value and simultaneously flatter EBITDA. So my answer is always 'it depends on the substance,' and I'd tell you exactly which evidence would move me from one treatment to the other. I'd also make sure the SPA reflects whatever we conclude, so it doesn't become a completion-accounts dispute."
That answer works because it refuses the false binary, names the evidence, and connects the classification to both the bridge and the earnings — which is exactly the judgement the role rewards.
Related-party loans are where the difference between reading a balance sheet and understanding a business shows up most clearly. The number is often modest; the ambiguity is not. Decide what the balance really is, price it accordingly on both sides of the ledger, write the treatment down in plain language, and get it into the SPA before it becomes someone's problem at 11pm the night before completion. Do that consistently and you will be the analyst the deal team trusts with the messy, founder-shaped businesses — which, in the mid-market, is most of them.
The Transaction Services Interview Programme (€119.99, one-time) includes a full module on classifying related-party and connected-party balances in the net debt bridge, with worked owner-managed cases and the exact interview scenarios that test substance-over-form judgement. Enrol today.
Hundreds of candidates prepared their interviews with this programme. Those who landed the role have one thing in common: they worked the cases before walking into the room.
