For those of you who tuned into Steve Reinharz’s (the AITX CEO) most recent ask me anything (AMA), you may remember I asked Steve some questions about a certain Canadian related party that AITX does business with. This topic area has also been a frequent AITX/Steve bashing topic. I think it deserves an article on the basics of this related party, how they’re remunerated, and to dispel some false notions.
Fair warning, this topic gets into my wheelhouse of corporate tax/finance, so as always, I’ll try to keep this as simple and straightforward as possible.
What is a Related Party?
According to US GAAP, a related party is defined as: “any party that controls or can significantly influence the management or operating policies of the company to the extent that the company may be prevented from fully pursuing its own interests.”
Let’s unpack that with a basic example. Say I own a company that makes pencils. Say I also own a company that sells pencils. From the perspective of the pencil manufacturer, the company that sells pencils is a related party, and vice versa. If I wanted to, I could ask the pencil manufacturer to sell its pencils to my pencil distributor for free, and there’s nothing the pencil manufacturer could do. Why is that? Because I own the shop!
In my above example I owned 100% of both companies. But if you didn’t fall asleep reading the US GAAP definition above, you’ll notice it doesn’t mention a percentage of ownership to be a related party. That’s because there isn’t one. In US GAAP, a related party is facts and circumstances based.
What does that mean? Say I own 100% of the pencil manufacturer, but 49% of the distributor. However, my 51% owner in the distributor doesn’t do anything and is a silent investor. I call all of shots. In that case, US GAAP would say they are related parties.
Conversely, say I own 49%, but my partner rules with an iron fist and I am effectively shut out of business decisions. This could be hard to prove, but one could make the case that the manufacturer and the distributor are not related parties.
Say my auditor says I have significant influence over my 49% owned company. I now must disclose any dealings made between the manufacturer (100%) owned, and the distributor (49% owned) as a related party transaction in my SEC filings.
One final note, you don’t actually have to own any shares in two companies for them to be considered a related party, or it can be a negligible number of shares. If you were the CEO of two companies and owned 1% of each, it’s highly likely your auditor would require you to disclose any transactions between the two companies as related party transactions.
What’s the Point of This?
Tax reasons aside, the purpose of these related party disclosures is to protect you, the investor. You should read any related party transactions disclosed in a report and be skeptical. Using the same example say the distributor is 51% owned by the public, 49% by me. If I was part of the 51%, I would want to know exactly how the distributor is dealing with the manufacturer. Is the 100% owner of the manufacturer giving fudged product pricing to the distributor to pad his earnings at the manufacturer?
You may think, how could that happen? Believe me, it does in the pennies. All the time. A very common structure is a nefarious guy or gal runs a consulting firm and all their buddies work for it. This person then starts a company doing whatever, goes public by selling 10 million dollars in common shares. The founder then enters a “management consulting” agreement between their consulting company and their new public company. They then charge suspect amounts of consulting fees to this public company, bleeding it dry. The shareholders are left with nothing.
That is a drastic example, but it has happened before and will happen again.
Arm’s Length Concept
You might be thinking, well if they’re related parties surely there’s a way you could still transaction fairly between the two related parties. There is, and it is detailed in IRS Treas. Reg. 1.482 in the context of taxation. That’s as technical as I’ll get, as much as I want to, but the general concept is this: related parties must transact as if they are third parties, or unrelated. If they meet that IRS criteria, they are transacting at an arm’s length.
In short, pricing must be fair to both parties and be materially close to the same pricing they could have gotten if they transacted with a third party instead. For example, the manufacturer could sell to a different pencil manufacturer. That unrelated price could be the same as the related party price to be considered fair.
What is the Canadian Related Party?
Now that you know the base concepts, what is this related party with AITX? In short, it is an engineering and technology development company located in Canada that Steve, the CEO of AITX, owns 49% of. The 51% owner is not known to me at this time, but it doesn’t matter. If you read my article on the E Series/F Series preferred shares, you’d know that Steve has the majority voting share of AITX. Also, via the F Series, he effectively owns roughly 70.0% the company at a minimum at any given time. That doesn’t include any straight common stock he owns.
If you were paying attention, your related party alarm bells should be ringing. The Canadian company is a related party to AITX, and Steve discloses it in their SEC filings. Under reporting rules, AITX must disclose the exact transaction amounts made each period with the Canadian company, and they do. To quote the 10Q for the period ended August 31, 2021:
During the three and six months ended August 31, 2021 the Company was charged $1,041,788 and $562,837, respectively in consulting fees for research and development to a company partially owned by a principal shareholder.
(Steve, you’re missing a period at the end of that sentence in the 10Q by the way).
To put that into context, AITX incurred about 1.3m in R&D expenses for the six months ended August 31, 2021. So the related party piece of that was about 1.04m, which is most of the cost.
Implications for AITX Investors
Now that you’ve read my basics, you should be thinking, “Is Steve transacting at arm’s length between AITX and the Canadian company? He’s bleeding AITX dry, isn’t he?! I knew the FUD gang was right – get the torches and pitchforks!!!”
Before you light your torches, let’s take a step back and analyze this. What would be a “fair” price for the Canadian company to charge AITX? This question in itself would require 30 pages of writing, but generally as a business owner performing tech development services, you would expect to earn some level of profit above your costs. Sometimes called a mark-up. For example, I have 100 dollars in costs, I mark up my service fees by 10%, so I charge 110. Easy.
This is what the arm’s length concept would lead us towards. The Canadian company should be charging AITX some amount of service fees such that it leaves an “arm’s length” level of profit in the Canadian entity. Fair and square!
However, you’ll notice AITX does not disclose how the Canadian company determined their prices. Thankfully, Steve was very forthcoming in the latest AMA when I asked him on December 5th. The Canadian company charges AITX at cost. That means the tech developers cost the Canadian company 100 dollars in salaries, equipment, etc., so they charge AITX 100 dollars, leaving no profit at the end of the day.
You’re probably thinking, “wait a second, you said the Canadians should charge such that they earn a profit, but they’re not getting one, that’s not arm’s length!” And it isn’t. AITX should be getting charged more than they are from the Canadian company. This is a direct, likely relatively small, benefit the AITX investors are getting. The shareholders of the Canadian company, Steve and the unknown other owners, are short profit they quite frankly should be due.
It’s that simple, AITX is getting an advantageous deal on the transactions with the Canadian company. Period. End of story. There is no story here other than the good deal AITX is getting and how the owners of the Canadian company, including Steve, are basically doing AITX a favor.
Related parties are two or more companies which have a single owner, or an individual who exerts significant influence over both parties either via ownership or position within a company. Transactions between related parties must be disclosed in SEC filings for investors. Investors must then use their best judgement to determine if the related party transactions are considered “arm’s length”, or in other words, as if they had been transacted between two unrelated parties.
The CEO of AITX has a 49% ownership stake in a Canadian company that performs the majority of the R&D and tech development for AITX. The Canadian company is fully entitled to receive some level of profit above its costs for performing these services, but it doesn’t. AITX is getting a great deal out of the situation. This is not a news story or anything to worry about as an investor. Ignore people posing this as a risk to AITX investors.
For further reading and AITX analysis, check out all of my articles HERE as well as in the sidebar.
DISCLAIMER – I CURRENTLY HOLD A LONG POSITION IN $AITX. THIS ARTICLE IS NOT FINANCIAL ADVICE AND IS INTENDED ONLY FOR EDUCATIONAL PURPOSES.