The importance of due diligence to the success of a transaction is often underestimated. I thought it might be useful to put together a few pointers to keep in mind while running a due diligence exercise on a business you are intending to buy. It is not a checklist – there are a few good due diligence checklists around – there is a good booklet available to subscribers of the Business Sale Report entitled ‘Due Diligence – over 1000 Key Questions to Evaluate Any Business For Sale’. You can download an extract here.

Plan it, scope it
Define the scope of the due diligence exercise and clearly mark out who is doing what, when. Work to a timeline. Don’t waste time on areas that are not likely to cause any real issues or have any effect on the final sale agreement.

Employee issues
Thorough due diligence should pick up any issues, risks and potential liabilities relating to the seller’s employees. For instance, check if there are any past or present employees litigating against the business. Do any of the employment contracts have unusual clauses i.e. over-the-top redundancy packages? What are the specifics of the pension plans?

Move fast, top down
It is important to spot any issues early on so that the appropriate warranties and indemnities can be quickly put in place. Focus on major issues first. As with any aspect of due diligence, the late uncovering of issues which lead to changed warranties and indemnities at an advanced stage can reduce strength of the negotiating hand and, (i.e. in the case of pensions) in some cases, even scupper the deal.

Communication is vital
The flow of communication between the buyer and his/her solicitors is of paramount importance, for if they do not work closely together, the process can quite simply fail.
Buyers must communicate the key issues of concern to the solicitors; they should not just assume that all areas are of equal importance, and that everything will be dealt with in good time. The solicitor must be told what the key commercial reasons are for the purchase, which areas are high-risk and which areas should be prioritised.
Continually monitor the activity of the solicitors and accountants carrying out your diligence and make sure they are giving you regular feedback.

Don’t forget the culture
Funny how the lack of understanding of the target’s company culture is one of the main reasons for failed acquisitions, yet has been notoriously ignored in the due diligence process. Don’t make the same mistake. This is usually one for the purchaser’s management to consider, rather than delegating to legal or financial advisers. Map out the management styles of your business and the target business. Look at the core values of each and analyse the differences. How do the communication structures and styles differ? Look at the dispute policies.

Collect information, then analyse
Don’t let any of your advisers analyse whilst collecting the information. These are two distinct activities within the due diligence process. First find out where the required information is, then collect the information, recording its source and noting whether it is fact or hearsay. Then start an objective analysis.

Don’t panic, take your time
A focused but comprehensive approach is better than taking shortcuts in order to reduce costs. Often the buyer discovers that ‘thin areas’ of diligence need to be covered again in more detail. It will end up taking more time overall and costing more money.

The current slowdown in the M&A marketplace now gives business owners a chance to look back and take stock after the breakneck pace of mergers and acquisitions in 2007.

Despite the recent trend towards corporate acquisitions, the majority of firms seem unable to deliver the full added-value that their takeover calculations had promised. Only nine per cent of mergers and acquisitions in Europe over the past three years have achieved their stated objectives, according to research from the management consultancy Hay Group. Their survey of 200 business leaders also found that under a third (28 per cent) said their merger created significant new value.

Note that this research is totally confined to the largest acquisitions and mergers in Europe and that it is well documented that smaller, controlled acquisitions enjoy a much higher level of success. Nevertheless, there are some very useful lessons that can be learned from larger company M&A integrations.

The figures for the UK are even more alarming, with only three per cent of larger mergers rated as successful.
Although the expectations for each M&A are different, in general they have to do with synergies. It is expected that the benefits from combining the assets, operations, and financial structures of two firms will be greater than the benefits from the two companies remaining independent. When such synergies fail to materialise, negative consequences arise such as destruction of market value, financial stability, impaired strategic position, organisational weakness, and damaged reputation.

Why do M&A fail?
There are many reasons why M&A fail to deliver expected benefits. They range from financial reasons such as large accumulated debts or an over-emphasis on early wins, to organisational reasons such as cultural disconnect and lack of leadership. However, one key reason for failure is the over-prioritising of systems integration over intangible assets and cultural compatibility, with some 58 per cent of respondents surveyed by the Hay Group admitting this had been a problem.

David Derain, a director of Hay Group who leads its work on M&A, says: ‘Integrating intangible assets six months after a deal has gone live is too late. Companies should be examining the compatibility and differences between the two firms well before the deal is made public.’

Collaboration, the process of various individuals, groups, or systems working together through joint planning, shared resources, and joint resource management, appears to be the key to success.

This can be achieved through

• Shared understanding of the issues
• Open communication
• Mutual trust
• Tolerance of differing points of view

Little over a quarter (27 per cent) of companies surveyed analysed the cultural compatibility of the businesses to be merged before signing the deal, while 59 per cent failed to prioritise a review of leadership capability within the two organisations. Ignoring the collaboration requirements of an M&A at each step can be a certain route to failure.

No shared understanding of issues: the case of shared vision
Failing to collaborate on a shared vision at the pre-merger stage results in the firm lacking direction, affecting the stakeholders of both companies: employees lack motivation and productivity falls, customers delay their purchase decisions and investors will lose confidence in the company due to the uncertainty about the future direction.
With the lack of a proper vision, the firm is neither able to retain nor attract employees. All these factors can lead to a failure in acquisition.

The success of post-merger depends largely on how well managers can persuade constituencies to believe in a vision and act to bring it about. This is a communications task, pure and simple. But it doesn’t just happen. It must be planned, controlled and carried out with commitment.
All relevant stakeholder groups-both internal and external-must receive communication about the transaction early and often.

Lack of mutual trust: the case of information withholding
When there is no trust in an M&A there is a natural hesitancy to share information. Unfortunately, current regulations restrict what management can tell the organisation without going to public disclosure. However, one thing is certain that a lack of real facts will put the employee rumour mill into overtime. Employees should be told as much as possible about the M&A and should receive explanations when they cannot be told all they want to know, preferably with an estimated date when they will be told.

Tolerance of differing points of view: differences in corporate cultures
In most mergers, the larger or acquiring partner simply attempts to impose its own corporate culture on the other partner. This approach, while valid in some cases, can destroy the value the merger was supposed to create if it is implemented badly.

The alternative to cultural imposition is for both companies to get to know their particular cultures during the pre-acquisition stage. From past experience it can be said that the set-up of cross-functional teams consisting of employees from both firms is a key success factor. This process may be very time-consuming and costly, requiring much commitment of human capital, but its importance is usually underestimated.

Lessons for management
Synergies – the most sought after prize in the world of M&As – are the improvements in performance following the combination of two businesses, relative to their expected performance prior to the combination. However, the most fundamental meaning of the word synergy is to work together. Therefore, by working closely together before, during, and after the M&A process, many of the related problems can be avoided or minimised.

Remember that businesses are a form of organism – a living, complex adaptive system of organs that influence each other in such a way that they function together like a stable entity.

Very often it is the physical systems and the accounting, tax and financial implications that get the attention, mainly because the City recognises these as measures of validity.

But the integration should focus on culture, the networks and the people that make up the organisation. ‘Soft’ factors maybe, but vital for a successful acquisition.