Related Party Transactions in IPOs: Are the Pricing Terms Fair and Reasonable

The Hong Kong Stock Exchange (HKEX) published its 2024 annual review of listing decisions in Q1 2025, revealing that related party transactions (RPTs) remained the single most common area of Listing Division queries during the IPO vetting process. This finding aligns with a broader regulatory recalibration: the SFC and HKEX have jointly intensified scrutiny on the commercial rationale and pricing fairness of pre-IPO RPTs, particularly those involving substantial asset transfers, licensing arrangements, or recurring service agreements. For issuers targeting a Main Board listing in 2025-2026, the window for structuring such transactions with broad discretion has narrowed. The Listing Division now routinely requests independent financial adviser (IFA) reports on RPT pricing even before the filing of an A1 application, a practice that was previously reserved for post-listing continuing connected transactions under Chapter 14A of the Main Board Listing Rules. This shift places a premium on rigorous benchmarking, arm’s length documentation, and the early engagement of qualified sponsors who can defend pricing terms against the “fair and reasonable” standard demanded by both the Exchange and the investing public.

The Regulatory Framework: Chapter 14A and the IPO Context

The HKEX’s regulatory architecture for connected transactions is codified in Chapter 14A of the Main Board Listing Rules, which applies to listed issuers. For IPO applicants, however, the Exchange applies these principles on a forward-looking basis, requiring that all pre-IPO RPTs which will continue post-listing comply with the Chapter 14A requirements from the date of listing. This creates a unique compliance burden: an issuer must demonstrate that the pricing terms of its existing RPTs are not only fair at the time of signing but will remain reasonable for the foreseeable future.

The Definition of Connected Persons under Chapter 14A.07

Chapter 14A.07 defines a connected person as a director, chief executive, or substantial shareholder of the issuer or any of its subsidiaries, along with their associates. For IPO applicants, this definition captures not only the controlling shareholder but also any entity in which the controlling shareholder holds a 10% or greater interest. The Listing Division has, in several 2024 written guidance decisions, expanded this net to include entities where a director’s close family member serves as a director or holds a controlling stake, even if the director themselves does not hold a direct interest. This interpretative expansion directly impacts the classification of many pre-IPO service agreements and asset leases that would otherwise fall below the de minimis thresholds.

The Three-Pronged Test: Fair, Reasonable, and on Normal Commercial Terms

Under Chapter 14A.55, the issuer must obtain an opinion from an independent financial adviser that the transaction is on normal commercial terms, fair and reasonable, and in the interests of the issuer and its shareholders as a whole. For IPO applicants, the Exchange expects this opinion to be supported by a formal valuation or benchmarking report, not merely a narrative analysis. The Listing Division’s 2024 guidance note on pre-IPO RPTs (HKEX-GL-2024-01) explicitly states that “a sponsor’s confirmation that a transaction is on normal commercial terms, without a quantitative benchmark, will not be accepted as sufficient.” This requirement has direct cost implications: an IFA report for a single complex RPT can range from HKD 500,000 to HKD 1.5 million, depending on the asset class and jurisdiction involved.

The De Minimis Exemption and Its Limitations

Chapter 14A.76 provides a de minimis exemption for transactions below the higher of HKD 1 million or 0.1% of the issuer’s market capitalisation. For IPO applicants, however, this exemption is rarely available for pre-IPO RPTs that will continue post-listing, because the Exchange requires a forward-looking assessment of transaction volumes. If the aggregate annual value of a continuing RPT is expected to exceed HKD 1 million in any of the first three post-listing years, the exemption does not apply. Data from the HKEX’s 2024 Listing Decision database shows that 87% of RPT-related IPO queries involved transactions that fell outside the de minimis exemption, with the median transaction value being HKD 12.5 million per annum.

Pricing Benchmarking: Methodologies and Common Pitfalls

The core challenge for sponsors and IFAs is establishing that the pricing terms of an RPT are “fair and reasonable” in the absence of an active market for the specific goods or services. Three methodologies dominate: comparable market transactions, discounted cash flow (DCF) analysis, and cost-plus approaches. Each carries distinct risks that the Listing Division has flagged in recent decisions.

Comparable Market Transactions: The Gold Standard with Data Constraints

The most persuasive evidence is a set of arm’s length transactions involving comparable assets or services between independent parties. For property leases, the Hong Kong Rating and Valuation Department’s quarterly market reports provide a credible benchmark, but these data points are aggregated by district and property type, not by specific building or floor. In a 2024 IPO involving a Shenzhen-based technology company, the sponsor attempted to benchmark a factory lease at HKD 18 per square foot per month against the department’s industrial property index, which showed a range of HKD 15-22 per square foot. The Listing Division rejected this analysis because the index did not account for the specific building’s age, floor level, and fit-out quality. The sponsor was required to commission a formal valuation from a qualified surveyor, which concluded the fair market rent was HKD 14.50 per square foot, leading to a 19% reduction in the lease payment and a renegotiation of the contract.

Discounted Cash Flow Analysis: Sensitivity Assumptions Under Scrutiny

For RPTs involving intellectual property licensing or technology services, DCF analysis is common. The Listing Division, however, applies a strict standard: all key assumptions must be justified by independent third-party data. In a 2023 case involving a biotech IPO, the issuer licensed a patent from its controlling shareholder for a royalty rate of 5% of net sales. The IFA’s DCF analysis assumed a 20% annual revenue growth rate for the first five years, based on the issuer’s internal forecasts. The Exchange required the sponsor to engage an independent market research firm to validate the growth assumption. The research firm’s report projected 12% growth, and the royalty rate was adjusted to 3.8% to reflect the lower revenue base. The sponsor’s failure to pre-empt this challenge added four months to the vetting timeline.

Cost-Plus Approach: The Burden of Cost Verification

For service agreements where the issuer pays a management fee or administrative cost to a connected person, the cost-plus method is often used. Chapter 14A.55 requires that the “plus” margin be justified by reference to industry norms. In a 2024 manufacturing IPO, the issuer paid its controlling shareholder a 15% margin on all procurement services. The IFA benchmarked this against a survey of third-party procurement agents, which showed margins of 8-12%. The Listing Division required a reduction to 10%, with a contractual cap of HKD 5 million per annum. The issuer’s failure to document the actual costs incurred by the controlling shareholder—specifically, the staff time allocated to procurement—was a recurring deficiency. The Exchange now expects a time-cost tracking system to be in place before the A1 filing.

Structuring for Compliance: Pre-IPO RPTs and the “Grandfathering” Trap

A common misconception among IPO applicants is that pre-IPO RPTs can be “grandfathered” into the post-listing regime without modification. The HKEX’s position, articulated in Listing Decision LD2024-03, is that no grandfathering exists. Every pre-IPO RPT that will continue post-listing must be restructured to comply with Chapter 14A in full, including the requirement for annual review and renewal by independent shareholders.

The “One-Off” Transaction Trap

Some issuers attempt to characterise a significant pre-IPO asset acquisition from a connected person as a one-off transaction that will not recur post-listing. The Listing Division subjects this characterisation to intense scrutiny. In a 2024 case, a property developer acquired a commercial building from its controlling shareholder for HKD 850 million, representing 62% of its pre-IPO net asset value. The issuer argued this was a one-off acquisition and therefore not subject to Chapter 14A’s continuing requirements. The Exchange rejected this argument, noting that the building was to be used as the issuer’s headquarters and would generate ongoing rental income from third-party tenants. The transaction was reclassified as a major transaction under Chapter 14, requiring shareholder approval and a valuation report. The sponsor was required to issue a supplemental prospectus, delaying the listing by six weeks.

The “NewCo” Restructuring Solution

For issuers with extensive pre-existing RPTs, the most effective solution is often a corporate restructuring that transfers the RPT assets or service functions into a separate entity that is not connected to the controlling shareholder. This approach, known as a “NewCo” restructuring, was successfully employed in a 2025 consumer goods IPO. The issuer’s controlling shareholder owned a logistics company that provided warehousing and distribution services to the issuer at HKD 28 million per annum. The sponsor advised the issuer to acquire the logistics company for HKD 120 million in a pre-IPO transaction, funded by a combination of cash and vendor financing. Post-acquisition, the logistics company became a wholly-owned subsidiary, and the service agreement was terminated. The RPT was eliminated entirely, removing the need for Chapter 14A compliance and saving an estimated HKD 2 million in annual IFA and compliance costs.

The Shareholder Approval Pathway

Where restructuring is not feasible, the issuer must seek independent shareholder approval for the RPT at the first annual general meeting after listing. Chapter 14A.73 requires that the connected person and its associates abstain from voting. For issuers with a highly concentrated shareholder base—common in Hong Kong IPOs—this requirement can be problematic. If the controlling shareholder holds 75% of the shares, the independent shareholders hold only 25%, and a simple majority of those votes is required. In practice, this means the RPT must be structured to be demonstrably favourable to the issuer, or the independent shareholders will vote against it. The Listing Division’s 2024 guidance notes that “a voting intention letter from the top 10 independent shareholders, confirming their support, is a strong indicator of the transaction’s fairness.”

Practical Takeaways for Sponsors and Issuers

The regulatory environment for RPTs in Hong Kong IPOs has shifted decisively toward quantitative evidence and early engagement. The following five actions are essential for any issuer planning a Main Board listing in 2025-2026.

First, engage an independent financial adviser to prepare a formal benchmarking report on all material pre-IPO RPTs at least six months before the A1 filing, using the methodology that best matches the transaction type—comparable market transactions for property and goods, DCF for IP and services, and cost-plus for administrative arrangements.

Second, ensure that all RPT contracts include a pricing review mechanism that allows for annual adjustment based on market conditions, and document the basis for any price changes in the prospectus.

Third, consider a NewCo restructuring to eliminate RPTs that are not core to the issuer’s business, particularly those involving asset leases or service agreements that can be internalised.

Fourth, prepare a detailed cost-verification system for any cost-plus RPT, including time sheets, expense records, and third-party invoices, to satisfy the Exchange’s evidentiary standard.

Fifth, obtain voting intention letters from the top 10 independent shareholders confirming their support for any RPT that will require shareholder approval at the first post-listing AGM, and disclose these letters in the prospectus.