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TRADITIONAL DUE DILIGENCE IS NOT ENOUGH - Part 2
by Patricia Dodgen

In last month’s article we examined the premise that traditional due diligence does not give the full consideration to all of the critical factors necessary to make for a successful combination of two businesses  Business journal and newspaper headlines reflect how often mergers and acquisitions fail.  When traditional due diligence projects a positive outcome, what explains the eventual failure of the combination?  Most often these disappointing results occur because a deeper analysis of the systemic culture of the organizations is overlooked.  In this article I will discuss the “Critical Fit Criteria” methodology used to extend the due diligence process and give managers a deeper understanding of the probability of a successful partnership.

What do we actually mean when we refer to “culture” in a business context and how can it be objectively analyzed?  Over the past twenty years business literature has frequently focused on organizational culture.  Typically within that context, the authors have used that term to refer to the internal environment or atmosphere of an organization – the way things are done, what is valued and prioritized, how the company regards itself.  This is an important concept, but it does not easily lend itself to quantification and analysis.  In order to accurately evaluate the various critical components of business culture, it’s helpful to use a graphical model.

Systemic Organizational View

 

In the Systemic Organizational View shown above, the company or organization is depicted as a system made up of three basic and interactive elements, the Business constructs, the Environmental factors, and the People or human capital.  Within the Business constructs we find the defining elements of business structure, including the mission and vision of the enterprise, its programs and initiatives, goals and objectives and operating plans.  Within these elements are the strategy and roadmap of the organization, as well as the measurements it will use to gauge its progress.  The Environmental factors describe the external as well as internal structures and processes that impact and influence the operation.  They include the investors, the customers, and markets of the enterprise.  Within this model element we also find factors including the global economic systems and political climate and systems that are difficult for the business to influence or change individually.  The third element of the model shows the People or human capital aspect of the organization.  Within this element we inventory the resources, skills, talents and abilities of the personnel.  We also include the elements of trust, autonomy, adaptability and individual character.  At the intersection of the three model elements we depict the culture of the business, the juncture where the elements meld.  Every enterprise has its own unique and distinct culture.  It is the blending of these sometimes very diverse cultures that is the source of conflict and ultimately, the failure of collaborative efforts.

If we think of the model as a mobile, we begin to understand how changes in one model element impact and create motion in the other two.  Like a mobile moves and adjusts, the systemic model also adjusts and compensates for changes to the position or motion of any of its components.  Our systemic model is valuable for managing change within the enterprise by understanding this principle, and it is also the basis for determining and measuring the “Critical Fit Criteria” to evaluate the potential success of a merger or acquisition. 

How do we apply the same discipline to measurement of the factors in our model as we do to the traditional elements of due diligence?  Isn’t it true some of these items are highly qualitative, like trust and ethics?  These are the questions that typically cause due diligence analysis to be limited to numerical and quantitative factors.  However, we can develop objective measurement criteria for all of the model factors.

For example, within the People construct, one of the key elements and a “Critical Fit Factor” is trust.  We begin the evaluation of fit on the basis of trust by developing an objectively observable definition of what we mean by the term “trust”.   What do we mean by an “objectively observable” definition?  For “trust” an objectively observable definition would be, “Being worthy of others’ confidence because of a record of demonstrated expertise, sound decision making, keeping one’s word, delivering what one has committed to, fulfilling promises and obligations, and acting with integrity.”  This definition clearly states what behaviors qualify as “trustworthy” under this definition.  We can observe behaviors with general agreement as to what matches the definition.  Once we have developed the objectively observable definition, the second step to creating our Critical Fit Factor measurement is to define behaviorally what constitutes high, medium and low levels of this element.  For example, for “trust”, these benchmarks might be:

Low:  Not worthy of confidence, either because the track record is unknown or non-existent, or because of the demonstration of a flawed track record through poor judgment, failure to meet expectations or deliver on promises, or failure to act with honesty and integrity.

Moderate:  Worthy of some confidence.  Has demonstrated reasonable judgment and fulfilled most commitments and promises made.

High:  Worthy of strong confidence.  Possessing a track record of demonstrated expertise, sound judgment, and living up to expectations and commitments.

Outstanding:  Worthy of the highest confidence.  Possessing a long and strong track record of demonstrated expertise, excellent judgment, and fulfillment of commitments and expectations.

We can now use these benchmarks to characterize each company with regard to the element of trust.  Obviously, if our two candidates for the merger or acquisition are at opposite ends of the evaluation on this factor, we may anticipate difficulty.  If we complete this exercise for each of the basic elements in the rings on our model, we develop a more comprehensive evaluation of “fit”, as well as a framework for addressing post-merger or acquisition adjustment.

The following table summarizes elements of the traditional due diligence process as well as some of the elements we measure as “Critical Fit Criteria”.  We certainly agree that the traditional due diligence steps are valuable and should always be completed, but adding Critical Fit comparatives will greatly improve the probability of success of the project and bring a better balance to any evaluation.

Traditional Due Diligence:

Financial statement analysis

Strategic intent
Market profile
Customers
Shareholders
Competitors
Asset analysis
Employee agreements
Environmental regulations
Distribution
Organizational structure
Potential tax & legal issues
Goals & objectives

Critical Fit Criteria:

Knowledge management
Stakeholders
Physical systems
Political systems
Operating plans
Human capital skills & abilities
Trust
Ethics
Programs & initiatives
Adaptability/flexibility
Autonomy
Managing paradox
Inward vs. outward focus

By utilizing the Critical Fit Criteria in a matrix format we can quickly highlight those areas of significant difference from one company to the other. Once these areas are clearly understood, plans can be developed to adopt one or the other level for each of the criteria, or to adopt a blended level over time.  These explicit plans become the basis for the overall post-merger or post-acquisition change effort.

However, the change effort must be orchestrated from a clear understanding of our systemic model.  Earlier we compared the model to a mobile with a system of interrelationships between and among the rings.  In order to effect change within the new surviving organization, the inter-relationships of the rings must be clearly understood and articulated.  Once the inter-relationships are explicit, programs for change must be considered simultaneously for each ring.  For example, compensation plans and performance compensation must be considered in relationship to both the skills and abilities of the human capital side of the model, as well as within the context of the newly merged market.  In other words, it is imperative that the post-merger or post-acquisition plan has a specific strategy to maintain equilibrium among the three rings.  The tendency is to focus the plans very narrowly and concentrate efforts in only one part of the ring.  The forces for stability in the system tend to overwhelm the forces for change within any system.  Well-designed change is difficult in and of itself. Because of the amount of effort change initiatives require, in addition to the effort required to overcome the forces for stability in the other rings, too many scarce organizational resources are consumed in the process.  Without careful planning for change in all three areas of the systemic model, failure is almost inevitable.

In their recent article in the Harvard Business Review, Michael Beer and Nitin Nohria examine two very different approaches to effecting change within organizations, which they label the “E” and the “O” approaches.  These two very different approaches are very similar to the difference between the traditional due diligence measures and analysis and the Critical Fit Criteria.  Like Beer and Nohria in their article, I agree that a blended approach utilizing both sets of criteria yields the best results.  “Theory E is change based on economic value.  Theory O is change based on organizational capability.  Both are valid models; each theory of change achieves some of management’s goals, either explicitly or implicitly.” 1 The authors explain that Theory E change contends that shareholder value is the only “legitimate” measure of corporate success.  Managers who hold the Theory E view frequently utilize financial incentives, layoffs and downsizing as tools.  On the other hand, Theory O strategists feels strongly that if the price of stock is the primary focus, they will ignore the critical opportunity to develop corporate culture and human capital through individual and organizational learning with cycles of feedback and assimilation of the reflected information.  However, the obvious challenge is in utilizing two often conflicting sets of goals and measures.

Beer and Nohria suggest several key activities in order to manage the contradiction of Theory E and Theory O (traditional due diligence and Critical Fit Criteria).  They include: 1) very explicitly addressing the contradictions between these two approaches by being prepared to recognize and accept the paradox that may emerge from conflicting indicators, 2) focusing simultaneously on the hard and soft sides of the organizations, which is specifically exploring the similarities and differences in the results of both types of analysis, 3) planning for spontaneity in the acceptance of the change initiative by understanding that acceptance and assimilation of the changes will most successfully occur simultaneously upward from the bottom of the organization and downward from the top, and, 4) setting direction from the top and engaging people below.

In addition to the Theory E and Theory O approaches, it is extremely important to understand whether each company is inwardly or outwardly focused and to what extent.  This specific comparative alone is responsible for a number of highly visible failed combinations.  In next month’s article I’ll explain the difference between inward and outward focus in detail.  I’ll also begin to explore the joint venture and collaborative project – both forms of activity that can be vitally important to development of strategic advantage and new revenue streams, but much more difficult to analyze and “vet” in advance.

Until September, may your late summer be reflective and profitable.

1  Michael Beer and Nitin Nohria, “Cracking the Code of Change”, Harvard Business Review, May-June 2000, p. 133.


About the Author:

Patricia Dodgen is a Fellow of The Business Forum Association.  Patti holds a BS, Financial Management (Cum Laude), Clemson University, 1977 and has broad experience as a senior executive in financial, technical, and operational management for various industries. She has specialized consulting experience in the telecommunications, broadcasting, print media, and computer technology fields. Currently, Patti is working on a national project to redesign the fundraising activities of a major non-profit client. Within the scope of this project she has literally created a completely new approach for fundraising for this industry. She conceived of and built the business plan and financial models for a revolutionary joint venture in fundraising. Additionally, she is further evolving her methods and tools to create a system of applied benchmarks for an entire industry sector. 

Since co-founding Transformations Consulting Group in 1993, she has utilized her knowledge to develop the tools and methods to help organizations effectively manage the complex process of change for her clients. By utilizing her approaches, TCG's clients in the profit and non-profit sectors have learned how to navigate these changes by applying Transformations' techniques as the rudder. Working with clients including PBS (the Public Broadcasting Service), Gannett Publishing, the US Department of Justice, and the Corporation for Public Broadcasting, Patti used her extensive knowledge to create initiatives and programs to solve complex business problems. Her solutions mitigate conflicting organizational needs to creatively find "win-win-win" solutions for her clients. By utilizing sensitive, yet objective measurement techniques with customized and strategic criteria for success, Patti's solutions have yielded positive financial results in the millions of dollars for her clients. 

Her approach to business strategy and development evolved during her years with Dun & Bradstreet as a senior business analyst and with Digital Equipment Corporation (DEC), where she was a senior financial manager. At Dun & Bradstreet, Patti had the opportunity to closely examine and analyze the financial and operational successes and failures of a vast assortment of businesses of varying size within many industries. As a key senior analyst, she investigated, analyzed and developed conclusive responses to business questions for firms such as RJ Reynolds, Belk Store Services, Nucor and Bernhardt Industries. 

While with DEC, Patti's primary focus was on designing financial systems and tools to provide critical and time sensitive information to field management. This information was fundamentally important in allowing management to make key competitive and tactical decisions quickly and accurately. Through this experience in the highly volatile computer industry, Patti developed the financial methodologies and models that are the foundation of Transformations' consulting approach. 

Patti is a frequent speaker at national conferences on the topics of complex change management, strategic positioning and "managing by the numbers". 


Previous articles by Patti Dodgen:

Traditional Due Diligence is not enough - Part 1


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Website URL:  http://www.transformationsconsulting.com
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