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Due Diligence Drives People Strategy

Opinion Written by John Berry on 25th January 2017. Reading time: 5 minutes

Due DiligenceOne popular outcome for directors of a profitable firm in a buoyant market is to go for a buy out – selling the firm as a going concern to either trade or institutional investors. In some cases the management team will stay on, earning bonuses as the firm sustains profits. In other cases, the investor will want its own team in place.

Whatever the outcome, the whole thing from advertising for sale to transfer of ownership, takes some time – most likely between 12 and 24 months. In that period, the seller’s management team must adopt a specific approach to its people strategy. It’s not ‘business as usual’.

On the one hand, arguably, there is no need to worry about how people are treated and managed – the business is for sale and all that matters is the money. This attitude explains the focus of many accountants who base the projected profit and cash flow on present financial performance.

But as often said, past performance is no guarantee of future results.

On the other hand, logically, much can happen in the sale period. Owners will want to secure the very best price for the concern. And that won’t happen if staff competencies, motivation and behaviours are damaged or if a significant proportion of the staff body leave. Profit and cash flow will then be heading downhill – a fact easily detected by a buyer’s financially focussed due diligence.

So just what people strategy should a seller adopt?

Buyer and Seller Due Diligence

Firstly some context. Both seller and buyer may do due diligence. The aims in each case are slightly different. The buyer will want to reduce its risk. It will use any identified risks as argument to reduce the offer price. And if there are too many risks, it will withdraw its offer.

Inevitably financial modelling makes huge assumptions. Buyer due diligence aims to quantify all assumptions and confirm them as valid.

Seller due diligence aims, on the one hand, to ensure that the buyer’s due diligence does not uncover any significant risks. On the other hand, the seller will want to ensure that all questions that a buyer will ask will be easily and completely answered from information in the data room[1]. The vendor will want to show off the firm in its best light, thereby justifying the asking price.

There are some dependencies. A firm’s ability to earn profits now and in the future depends on its capability in its market. Capability depends on the staff competencies, motivation and behaviour and on the technology function that the staff body uses. Capability spans all seller operations: R&D, marketing, sales, delivery and support.

Dependencies illustrate where the risks might lie and where the seller might want to take action to secure the highest sale price. The dependencies and necessary actions illustrate the people strategy in the lead up to a sale.

In a due diligence in which a TimelessTime consultant advised, the asking price was £42million. The consultant’s task was to determine if the firm was capable of addressing future market needs. This involved assessing the capability in sales, marketing, R&D and manufacturing. In the end a price of £40million was agreed. The capability was pretty much as the vendor said.

So how do we determine the people strategy?

First to the risks.

Identifying People-related Risks

All employees must have employment contracts and offer letters. There must also be a staff handbook and a set of policies and procedures. Weakness in this document set, such as people without contracts and out of date policies, is a risk. When the buyer attempts to implement a robust set of documents, many costly irregularities may be uncovered. It also goes without saying that payroll and pensions data should match the contractual commitments.

Unrest in the staff body and messy disciplinaries, grievances, absences and dismissals also heighten risk. A buyer will have to expend significant management time, and potentially costly settlement agreements, to reach a satisfactory state after purchase. The reason for unrest – in areas like poor comparative justice rooted in a poor pay structure – needs to be understood and corrected.

And possibly the biggest risk centres on non-existent or poorly written job descriptions and associated person-specifications. Job descriptions should contain both a statement of the job purpose and accountabilities and a statement of the competencies that the jobholder should exhibit. Add to those two the function of the technology employed by the job and this describes exactly individual employee capability. The capability of the firm is the aggregate of individual capabilities. It’s this capability that must be maintained in the period up to the sale and beyond. It is after all this capability that the buyer is buying.

At a corporate level, a competency framework can illustrate the aggregate competency of the firm. Competency gaps can then be worked on before buyer due diligence.

We can now see the bones of a people strategy for the firm for sale.

Significance of KPIs

The start point for all strategies is the key performance indicator (KPI). For people strategy, possibly the most important KPI is the turnover per person. This then has a number of derivatives: turnover per direct employee, profit per employee and profit per direct employee. Direct employees are those who are in operational roles, as distinct from indirect or supportive roles. The ratio of direct to indirect is also important. These KPIs are significant because they indicate how well the firm is securing its profits with the staff body in place. The buyer will use data on similar businesses for comparison. Any improvement in the £/employee ratios is a benefit.

Any deterioration of those KPIs indicates that the staff body is not functioning as it should. And if these ratios are significantly below competitors, this could put downward pressure on the price.

The strategy must therefore be to sustain the KPIs and build on them – thereby indicating to the buyer that the future of the firm is secure.

Finally, one of the biggest dangers in transfers of undertakings is the loss of motivation. Management must re-double its effort to sustain this. Loss of motivation soon hits performance and this in turn hits KPIs. Where poor motivation (and ultimately poor performance) comes from poor culture, this too must be improved.

Motivation works to secure positive pro-social and desirable behaviours though the job that each person does. Motivation comes primarily from those jobs and it is therefore key that management continues to evolve and sustain job quality – particularly if they tinker with jobs to cut costs. This is likely to be secured by maintaining leadership interventions and communications throughout the sale period.

In summary therefore, when a firm is up for sale, risk of deterioration of KPIs is very real. Threats abound.

Importance of the Psychological Contract

The watchword, or watch-phrase, is the psychological contract. The psychological contract is underpinned by the economic and legal employment contract and associated policies and procedures. This document set must be sound.

The psychological contract is all the unsaid hopes and expectations of the staff. Staff who are well led with interesting and well defined jobs to do in a positive culture will maintain their motivation and performance.

That then leaves the big activity to quantify the staff body and illustrate that the aggregate skills and knowledge will sustain the KPIs over the sale period and for five years or so after sale. With that goes associated technology function.

And it goes without saying that all turbulence with staff must be eradicated before buyer due diligence begins: all disciplinaries, grievances, tribunal claims and dismissals must be resolved.

Due Diligence Drives People Strategy

As the strategy turns to action, associated documents supporting the positive arguments about future performance must go to the data room to support the financial, operational and market information.

  1. The data room is the physical or online repository where all data that the buyer might want is stored. Access by sellers is though a non-disclosure agreement.

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