In M&A, What You Don’t Know, Can Hurt You

I’ve seen my share of acquisitions and had the good fortune to have led a few as well as teaming with others to do the same. While I can’t take credit for the expression, someone once wrote that when romancing a company you seek to acquire, you look for all the reasons it will be a perfect marriage and then during due diligence, you look for all the reasons it won’t. This is about the latter.

Accountants and attorneys play an invaluable role in protecting a buyer, first in the due diligence phase and then in penning a final contract. Unfortunately, from what I’ve experienced and others have shared, buyers sometimes overlook a few extra steps either because of trust, expense or raw confidence. It’s easy to evaluate equipment and facilities being acquired and almost as easy to determine the quality and strategic importance of the customer base; what’s not so easy is uncovering undocumented practices and assessing the value of key management being asked to stay on.

From my archives, here are four of the more painful discoveries made along the way.

• “Hidden costs” – a manufacturing company was successfully acquired and the selling founder retired as part of the transaction. Two months after new ownership took control labor productivity dropped like a rock. It took a while, but eventually the new management team discovered that the previous owner would walk through the plant at month end and hand out crisp $50 bills. Once he was gone, and no one passed out cash at the end of the first month, the work slowdown began.

• “Past practice” – a successful acquirer had an awkward conversation with a major customer. Apparently there had been some verbal arrangements the previous ownership had made with the customer and the customer became concerned when those arrangements seemingly had been abandoned.

• “Background” – a sales executive was asked to continue with the acquiring company and offered an improved compensation agreement to do so. He eagerly signed on. Six months after the change of control, he was arrested for driving while intoxicated (DWI), while driving a company vehicle. Sadly, this was a second violation; he was sentenced to weekends in jail and his license was suspended for a year.

• “Foreground” – a CEO borrowed more than $1million from peers he knew through a professional organization to fund the acquisition of a much larger company than the one he managed. The target was in a dynamic market with some related technology—but barely breaking even. It didn’t take long; the combined entity began to bleed cash, to the point that its commercial lender put it into workout.

In the first case, an audit would not have found the practice of $50 cash bonuses; it might have found “disbursements” to the owner at month end, but there the trail would have gone cold. Persistent questioning of the CFO and the production manager about off balance sheet transactions, unrecorded perks and the like may have surfaced the practice.

This same approach may have yielded results in the second case – e.g., “is there anything we should know about special arrangements you have with specific customers?” At least here, if there was denial, there would be the potential to recover through escrows set up for such purposes.

The matter of the sales executive with the DWI is the most disturbing and yet, had the highest probability of being avoided. In my opinion, due diligence should always include comprehensive background checks of executives being invited to stay on under new ownership; to do so, their written consent is required. Had such a check been done here, the sales executive would not have been hired and possibly, the company not acquired.

As to the company put into workout, the due diligence process had accurately reported the acquisition’s condition and the associated risks. What the private lenders failed to do was comprehensively assess the skills of the acquiring CEO and his abilities (and plans) to manage an entity so much larger than his own.

We get one chance to look under the sheets, to find the flaws, to discover the unspoken practices and understand the true character of the leaders included in the acquisition.  After that, we bear the brunt of what we missed. Turn every stone, persistently question many, not just one, and question again. Above all, if what you find sinks your probability of success, have the courage to walk.

Lessons learned, the hard way.