An M&A Process That Creates Value: What Every CEO Should Know (Part 2 of 3 – Due Diligence on the Target)4 minute read

Part 1 of this primer focused on creating a sound mergers and acquisitions (M&A) process, and the importance of planning the acquisition investigation, incorporating written work plans, and involving information technology and enterprise systems within the target company. The process should be intentionally designed in order to result in the most optimal outcome. For more information please read, Part 1 – Planning and Strategy.

Part 2 will describe how small-cap CEOs can better understand the business culture of an acquisition target and the potential for friction between workforce cultures, attitudes, and compensation schemes.

Focus On The Target’s Culture, Not Simply Its Financial Performance

Perhaps the most important thing that a CEO does within an organization is to create and manage the culture.  When a business is being acquired, its culture may (or may not be) a good match with that of the acquirer’s.  Unless the cultures mesh — or can be made to mesh quickly following the acquisition — friction is likely to result, and the hoped-for results may be more difficult to obtain.  Buying a dysfunctional or dishonest culture is the hidden risk in any acquisition.  Integrity is paramount, and indications that it is lacking in the target is usually a danger signal that the transaction does not make sense.

Employees accustomed to doing things one way can quickly grow to resent significant changes in their daily routine.  If the target’s culture is free flowing, while the acquirer’s culture is more structured, then “top-down” friction is predictable.  Conversely, if the target’s employees are accustomed to having their every move directed from above, and suddenly find themselves in a culture in which employees are expected to be self-directed, wandering can result.  Therefore, thoughtful planning about culture gaps and differing management styles is crucial.

Does the Target Operate Differently?

Closely tied to the issue of culture are the target’s business practices.  The target may have compensation policies (particularly in the way it awards its sales force) that are inconsistent with the acquirer’s practices. The CEO should assess whether it will be possible (and necessary) to maintain those differences following the closing, or whether the target’s compensation plans must be modified (immediately or eventually), risking departure of key players.

Arrangements with customers must also be examined.  Are the target’s warranties, return policies, or other dealings with its customers inconsistent with the way in which the acquirer deals with those issues?  Should those differences be maintained and, if not, what would be the impact of changes on financial plans and models.

The ways in which the target secures its business is also an area of increasing concern, particularly in emerging or foreign markets, or in cases where the target does business with domestic or foreign governments.  If the target uses intermediaries or gatekeepers or pays incentives or facilitation fees that the acquirer cannot lawfully continue following the transaction, the anticipated loss of business should be quantified and modeled as best as possible.  If the target is succeeding by doing things that the acquirer cannot do, the question must be asked: “Will the business succeed when we own it?”

What Can The Target Do That We Cannot Do?

Some acquisitions are motivated solely by a desire to increase the size or scope of an enterprise, while in other cases, synergies in the form of cost reductions are the motivating factor.  More often, however, small-cap acquirers are seeking a target that brings some additional value to the table in the form of intellectual property, strong management, specific customer or supplier relationships, complimentary products or other strategic advantages.

Acquisitions are “build-versus-buy” decisions in which the acquirer elects to purchase a particular capability rather than develop it organically.  It is generally accepted that the costs of an acquisition exceed what it would take to grow the same assets organically; however, the acquisition allows progress more quickly.  Where speed is not crucial, however, companies may wish to rethink whether an acquisition versus internal development of the capability makes sense.

It is important that the CEO communicate the drivers for the particular acquisition to the deal team.  Armed with this information, the deal team can perform its due diligence and negotiation functions with greater focus.  Knowing what you are trying to achieve, capture and protect against is crucial.

Part 3 of this series describes how to manage present and emerging risks that can crop up in any M&A transaction.