The Human Side of Due Diligence

a view through the looking glass

This never happens, right?  You wade through the teasers, pour over books, work up a few LOIs to get a couple of promising businesses. Then you go through your whole due diligence process.  The team tackles the financials, talks to a few customers. You interview top executives as well as some key contributors they point out. Everything looks good. You make your selection and you close.

Less than a year later you wonder if you’ve dropped into an alternate universe. You can’t believe it’s the same company. Performance is down. There are untold levels of executive drama. Overall company morale has vaporized and those key contributors have left the firm.

What happened?

People happened. The company is full of them. They have issues. Issues with each other, with themselves and with anyone coming in from the outside. These issues become well integrated into the operation, essentially masked by processes, procedures and reporting structures. You probably spotted the inefficiencies, but the root causes are what blew up.

When you change the ownership of a company, you break an emotional contract that exists with every employee. You inject a level of uncertainty into the whole organization, from senior management to the front line. Past value assessments, assumptions, alliances, “tolerated” relationships are out the window. Senior management is distracted, and has been throughout the vetting process. Everyone else is grasping for the “new normal”.  They are pre-occupied with re-establishing that emotional contract in the context of the new world order. Worst case is that things degrade to “every man/woman for themselves”.

By the way, standing up at the company meeting and saying “we love you guys, nothing will change, just keep doing what you’re doing” is perceived, rightly or wrongly, as bullshit.  Always.

How did these issues get missed?

Well, to be honest, you probably weren’t looking. It’s not something that’s on the front burner of business assessment. Sure, you talked to a few folks, but not too many so as to maintain confidentiality through the deal process. Besides, subjectively, everything seemed to be running smoothly.

Your team is well trained in the quantitative methods.  In fact, they’re explicitly focused on objective assessment, lest emotion unduly influence the buy decision. In addition, there’s never enough time. Maybe there’s a funding window, or time sensitive market opportunity that’s driving the deal. The team is running flat out. Thus, neither the process, nor the team charged with carrying it out, allows for a meaningful assessment of the company culture.

There’s got to be a better way.

There exists, in every enterprise, an informal structural network that supports, and many times supersedes, the official one. This is the one that reflects (to steal McCregor’s book title) the human side of (the) enterprise. Just as with the formal structure, operational and financial data, this informal structure can be analyzed for stress points, vulnerabilities, and even a few hidden gems.

Figuring it out, though, is a very different process requiring very different skills. It also involves far more members of the target company. Since it’s usually not desirable to telegraph your intentions, adding an army of industrial psychologists to the due diligence team to test and analyze the company psyche is impractical. Nor is it financially justified. Except for extreme situations, where it may detect a ticking time bomb, the impact of this analysis wouldn’t be a deal breaker as much as ‘transition smoother’.  The results are more likely to be the difference in a couple of points swing in the multiple, top line and EBITDA. In essence, the difference between a winner and a yawner.

The practical approach is to send in a seasoned operations specialist as a separate exercise, which can precede, coincide or lag the on-site due diligence team. This person must be able to relate to front line staff, middle management and senior execs in a way that promotes openness and trust in 1:1 settings. S/He needs diverse experience to assess a broad range of situations on the ground. Most importantly, they need the emotional intelligence to frame questions and analyze answers in the context of informal structure.

Oh, and if the current owners balk at such an exercise, well then you’ve learned something critically important before making any commitments.