Quadrant IV: Quantum Leap
Step 2: Doing Due Diligence on the Targeted Acquisition
Case Example: Dow Chemical’s Criteria for Targeting Acquisitions Dow Chemical has its criteria for targeting potential companies, which Randy Croyle sums up here:
We look to understand what their product lines are, look at what their financials are, try to get an understanding of what are the risks of that target company, be it their product lines, what is their litiga- tion history. Typically, we will have that type of analysis done by individual businesses, or if it is a corporate play, where it is an acqui- sition that would cross over multiple business lines, we would be understanding exactly how each of those business lines would fit into the overall corporate business strategy. We look at potential acquisi- tions both from a corporate standpoint and from a local, individual business unit point of view.
Step 2: Doing Due Diligence on
innovative and efficient buildings that will enable the newly combined firm to forge or penetrate new markets.
Some generic capabilities that can be highly relevant to whether the proposed merger or acquisition will succeed are whether the targeted company has the capabilities for
• Developing and retaining its people
• Generating innovation of market-defining goods and services
• Cultivating customers
• Supporting high-performance technological outcomes Case Example: SAIC’s Criteria for Targeting Acquisitions
SAIC has had a more decentralized structure, and therefore most initiatives for acquisitions have originated in specific business units. An effort is cur- rently underway to have those initiatives align with the new CEO’s require- ment to double the revenue of the overall company. Even so, that effort is leveraging the extensive capabilities that already exist within the business units to bring them up to the level where they meet the requirements to real- ize the corporate goals.
Concerning the selection of targets for acquisition, Kevin “Ed”
Murphy, senior vice president and director of mergers and acquisitions of SAIC, states:
The business units “know a dog when they see it” and feel less inclined to fall in love with the deal because they have their own strong base to fall back on. We have had folks who pass on several deals, although it looks like a decent deal, because it is not good enough for them. We look for the business folks, who are the sponsors, to apply their good business practices and judgment. If they are walk- ing away from an acquisition that we think is a good deal, generally my approach is let them walk away from it, because you can’t force them into an area of noncomfort.
One area that has been a lesson learned is that the better-per- forming and better-talented business units do the better deals. This is not a coincidence. Also, if the target company’s management is well skilled, and the day after the deal closes, from their point of view, all they have to do is figure out where the SAIC rulebook is. . . . In the past, our business leaders did not know how to do the integration.
Their approach has been, “Here is how we do things.” They are get- ting more sensitized now.
Structuring Due Diligence
Due diligence for different acquisitions will have the same basic elements but will also be shaped by the specific nature of each transaction and the needs of the acquiring company—and, to some extent, the needs of the acquired company. Each due diligence is an extension of your company’s strategy and, at the same time, is a basis for the follow-up negotiation and implementation stages. If M&As are considered a major part of your company’s overall corporate strategy, you may have be a formal center for managing M&As, as Dow Chemical has.
Every acquisition has elements in common with other acquisitions, but each, for any company, also has its own character and specific com- plexities. One acquisition may be made primarily for technology capabil- ities, another for sales and marketing capabilities, a third for product and service lines, a fourth for customer sets, and a fifth for physical resource reserves. In addition, there may be different degrees of integration for dif- ferent acquisitions. Generally, the more fully the acquired company is to be integrated into the acquiring company, the greater the need to under- stand how the two companies can create value in as many ways as possi- ble through capability synergies, while at the same time finding opportunities to capture expense savings. In some cases, integration will be limited and the acquisition will operate fairly autonomously. Even so,
Case Example: How Cisco Handles Due Diligence
Cisco has been so successful at acquiring other companies that an entire book has been written about its process: Inside Cisco: The Real Story of Sustained M&A Growth. Here’s a brief excerpt about how Cisco conducts more than just financial due diligence:
Due diligence at Cisco is more than just verifying the financial, legal and asset value status of a target company. It is a test—a test of ethics, honesty, team spirit, professionalism, and customer commit- ment. Notice that these items don’t appear on a balance sheet, an income statement, or a statement of cash flows. . . . Underlying the due diligence process is the search for the answer to an overriding question: “Will these people, their products, and their culture merge well with Cisco’s so that they will be seamless with Cisco within a few months?”12
Case Example: Dow Chemical’s Mergers and Acquisitions Expertise Center
At Dow Chemical, all acquisition initiatives must go through the head of its Mergers and Acquisitions Expertise Center. That leader is in charge of a team with an array of skill sets in finance, negotiations, due diligence, oper- ations, and processes.
After the center’s leader accepts going forward with an acquisition, he and his staff decide how they will handle due diligence, negotiations, and, where possible, implementation as well. They map out the strategy and process for the preacquisition phases with the head of the business unit involved. As Dow’s Croyle says:
I have a list of what I call functional focal points. I’ve got a very senior person in each one of our functions, and I routinely interface with them. So, if a deal is coming down, if we feel we need somebody out of HR, or we need somebody out of our environmental health and safety organization, I work through these functional focal points.
Either they themselves will be the person or they will then delegate that to somebody within their organization. It is a big chunk of time that is involved. It is something that is over and beyond their normal day job. They have to make the adjustment if they are going to keep all of these balls in the air.
We have a kick-off meeting with the due diligence team. That meeting gives them the scope of the due diligence—what is the strate- gic intent, what are we looking for, identifies what the boundaries are, gives them an idea of the time line. Then we go with them to the data room or to the site visits. At the end of that period of time, we will have a number of debriefing sessions. Before they are excused, they have to put everything in writing. We use those documents to help with the valuation, but those documents are also the start of our implementation plan.
Every one of our functions has a checklist and a template that they use. That is something that we put together when we developed our “corporate M&A” process. Part of that was to get standardized checklists, protocols, templates, and other materials for all of our functions as they went forward on due diligence.
Whoever is on due diligence, we try to get them involved during the implementation phase. Likewise, we try to put the folks who are on due diligence close to the negotiating team and, if possible, on the negotiating team. If the acquisition has a lot of manufacturing assets, we will try to put the manufacturing persons who were on due diligence on the negotiation team. Or, if we anticipate that there are a lot of HR issues, the HR person who is on the due diligence team will also be part of the negotiating team. Continuity of personnel across these different phases is very important.
good leadership in holding companies and conglomerates can enable a flow of the best managerial methodologies and capabilities across all of these companies’ autonomous business units.
For example, when Hajoca, a large construction supplies company, acquired Emco, one of Canada’s leading integrated distributors of plumb- ing supplies, Emco continued to operate as an autonomous business unit, but it adopted a number of managerial processes that were developed in Hajoca’s cluster of companies, including a new compensation approach for profit sharing.
Each due diligence emphasizes a different configuration of readi- ness and capabilities. The due diligence teams that your company assem- bles should reflect your company and its acquisition strategy. The team should gather and review different functional focal points with the view that the information it discovers will guide managers in making the fol- lowing decisions:
• Whether to pursue the acquisition
• What pricing range is workable and acceptable
• What areas and issues to negotiate
• What inputs are needed for developing a business plan that will shape and guide the integration
Also, keep in mind that you need to balance the time spent on due diligence in order to achieve all of the following (and often conflict- ing!) goals:
• To optimize the limited time available for due diligence
• To take into account the degree of confidentiality or nondisclosure requirements involved
• To consider the need to gather adequate and relevant information for decision makers
This requires the acquisition team to define its due diligence objec- tives rigorously and communicate them clearly and fully to everyone involved.
Generally, the people on due diligence teams are drawn from across the company, and they participate in due diligence in addition to their regular responsibilities. They usually become members of due diligence teams on an as-needed basis, with some serving part time and some serv- ing in a full-time capacity. By keeping them aware of what makes for effective due diligence, the M&A team can readily involve the members of the due diligence team as needed. In a sense, this is like having fire- fighters trained in a fire company drill so that they are ready when the call comes. Continuously building a network of qualified participants is another illustration of how organizational readiness creates the basis for the specific capacities to carry out the acquisition process.
Although the traditional emphasis of due diligence has been placed heavily on financial and accounting reviews, the due diligence team needs to consider a full range of issues, including
• Cultural factors
• Technology
• Leadership and human capital resources
• Communication
• Customer relationships
• Legal and regulatory requirements
The particular configuration of factors that is important to a com- pany will determine any special emphasis on the team. For example, the due diligence team of a major chemical company for which R&D is a major driver includes participation by R&D staff, an intellectual property lawyer, and people from manufacturing technology. Other companies will have more of an emphasis on environmental safety, the ability to per- form in financial markets, or other factors.
The Importance of Trust
The importance of trust in acquisition relationships is extremely criti- cal. Making every participant take on the role of an ambassador changes the relationship from an impersonal (if not hostile) takeover to a
Case Example: How SAIC Handles Due Diligence
SAIC is a technology service firm that puts a strategic emphasis on serving its key customers. The loss of one of those customers would have a serious impact on the company’s well-being; therefore, customer service is part of its due diligence process when targeting possible companies for acquisition.
Here’s how SAIC’s Ed Murphy describes the process: “A critical piece of due diligence is talking to customers face-to-face. We are always thinking of the customer and making sure that they are comfortable with the company that we are buying as well as with us. We are very customer-centric in that approach.13
SAIC is also careful to tell its due diligence and integration teams that they are not simply doing financial or technical due diligence. Beyond that, they are ambassadors to the company. Someone from a due dili- gence team has one chance to make an impression on the company. If team members go in and set the target company on edge, you can be nice the next five times and the target is still waiting for you to treat them poorly, because that is the impression you have left. We encour- age people to be ambassadors, to do the job, but to have a balance.14
respectful, collegial knowledge sharing. If people at the target company come to believe that they are potential partners in a new company, they will be more collaborative and perhaps even indicate issues and oppor- tunities that might not otherwise be noticed. Trust in a partnering ori- entation sets the tone for how negotiations and later integration will be carried out.
At the same time, due diligence is a process of refining what is known and what needs to be known. It starts out at a high level, and as informa- tion comes to light and is reviewed, more and more critical questions are asked until the knowledge obtained allows the acquiring company to deter- mine whether to proceed (and how) or whether to terminate the acquisi- tion initiative. Therefore, it is understandable for the target company to be prudent and reveal only what it needs to; after all, the deal may not go through, and even if it does, the target company still needs to be in the best possible position to negotiate the best outcome for itsstakeholders.
Case Example: Clarica Life Insurance Company
Clarica demonstrated that having knowledge capture and transfer capabili- ties enabled it to move quickly when an unexpected acquisition opportunity arose. That capability made the difference in its bid for the Canadian oper- ations of Metropolitan Life Insurance. At that time, Clarica was embarking on a highly resource-intensive shift from being a mutual life insurance com- pany to being a stock company (demutualizing).
Just as Clarica was focusing significant resources on demutualizing, an extraordinary opportunity to make a major acquisition arose when the Canadian operations of MetLife became available. Clarica recognized that several other bidders would also be very interested. It knew that it would be successful only if it was able to move quickly, because the first bidder to complete the due diligence process and indicate a possible price range would probably get to the negotiation stage. It also needed to use the least amount of resources possible because it had committed substantial resources to its demutualization.
Within three weeks, Clarica organized 150 people into 16 teams, each targeting a component of the deal. From the beginning, the teams were linked by a common knowledge database, where they filed findings, raised questions, identified issues, and found creative ways to resolve those issues.
This allowed every individual on any team to know what was happening with everyone else who was part of the process. Because there was very little time for managerial intervention, team members were the ones who identi- fied issues, found solutions by building on each other’s ideas, and then moved on to the next concern. Through the teams’ efforts, the due diligence and business planning processes for the “integration” were completed in record time.
The quality of the preparation work was so good that the negotiations were carried out in a fraction of the expected time. Clarica negotiators found that they often knew more about the business being acquired than their counterparts in the target company who were sitting across the table from them. The knowledge acquired through the due diligence process put Clarica in an advantageous negotiating position because it could make and justify its offer much more quickly and better than any of the other suitors.
The result was that Clarica was able to acquire a company that was 50 per- cent of its size at an advantageous price. Focus and teamwork, enabled by the knowledge strategy, provided a decisive advantage in speed and agility.
Clarica replicated this same approach for other acquisitions and found that it could readily reuse the processes and templates from the earlier acquisi- tions with equal success.
Knowledge Capture and Transfer Capabilities
The strength of the business plan is in large part determined by the qual- ity of the due diligence effort. Good due diligence information allows the company to identify possible expense savings and complementary capa- bilities. The knowledge derived from due diligence is used to build the foundation for the integration plan.
Due diligence is not just a requirement for determining value. It is also a way of thoroughly and tangibly operating. Although there is a due diligence stage in a merger or acquisition, the principles of due diligence need to be present and practiced from the very beginningand throughout the transaction process.
In the value-creating approach, due diligence applies the principles of strategy making, which means that the acquirer is constantly renewing its acquisition strategy to take into account new knowledge that emerges from the due diligence process. This dynamic strategy approach leverages the new understandings flowing in from the due diligence team, shed- ding light on how both expense saving and capability synergies can best be captured and leveraged at all stages of the M&A process.
The due diligence process needs to encompass the following practices:
• Using a “bifocal” approach that takes into account not only expense synergies (i.e., duplication of expenses) but also growth synergies. The result is that your company will get a longer and broader view of potential combinations, what value could be created through the acquisition, and what savings could be
Case Example: Dow Chemical
Dow Chemical makes a practice of knowledge capture and transfer, along with continuity of personnel from due diligence, as a critical input for its implementation plan. According to Randy Croyle: “We have continuity because when the due diligence team is visiting a data room or a site, knowl- edge that is picked up during that visit is extremely important and is trans- ferred to the people putting together the implementation plan. The best way to transfer that knowledge is to have continuity of personnel. That is another key learning for us.”
accrued. This sets the stage for determining what price you should be willing to pay for the target company.
• Using an “accretive” approach that enables your company to add to earnings per share as soon as possible. This approach looks for acquisition synergies that are expected to increase earnings per share. This may mean looking for opportunities for such things as cross-selling of the acquired company’s services to the acquiring company’s client list or turning the acquired company’s research into salable goods and services, all of which will have a
significant impact on your bottom line. The value-creating approach emphasizes pursuing both short-term and long-term opportunities for gains, but in a more holistic framework.
• Recognizing the relationship between the due diligence process and the shaping of your business plan. Doing due diligence provides information that leads your company to be more exacting when negotiating the deal and when integrating the company following the purchase. This knowledge helps frame your business plan; it enables you to look at a range of options to see what is possible and what is not possible; and it helps you determine what to give up on (and what not to) in the
upcoming negotiation and integration phases. If you follow this process, at the end of the due diligence period, your business plan will be well into its development.
• Setting the ground rules for establishing an atmosphere of trust and a partnering context.
• Checking whether the assumptions of your business plan are holding during the due diligence process and beyond, and determining what modifications you need to make.