Why HR Due Diligence Is an Important Step in a Transaction
Why HR Due Diligence Is an Important Step in a Transaction
'Workforce in Transactions' or 'Human Resources Due Diligence' evokes different ideas for different people. We often get asked "what is Workforce in Transactions?" and "why do Human Resources Due Diligence?" This article will aim to cover both questions, including our top eight reasons why organizations should perform HR Due Diligence.
What Is Workforce in Transactions?
Breaking it down, a 'transaction' is any sort of merger, acquisition, carve-out, spin-off, major restructuring, etc. 'Workforce' or 'Human Capital' refers to the people related to the organization (employees, contractors, consultants, founders, owners, etc.), the renumeration they receive (equity, cash compensation, benefits, other entitlements, etc.) and the ways the organization supports these people (HR function, HR systems, organizational design, communications, change management culture, etc.). In most organizations, the people costs are some of the highest costs an organization has — which presents both opportunity and risk. Exploring the opportunity and risk ahead of a sale is the due diligence process which is structured and methodical. It involves reviewing data on the organization and its people, speaking with management and performing different analyses depending on the context of the situation. Findings are then summarized and incorporated into the financial adjustments and purchase agreement considerations. These workforce-related financial adjustments often have an impact on the overall purchase price as, typically, purchase price is a multiple of adjusted earnings.
8 Reasons to Do HR Due Diligence
The people costs of a business are usually some of the largest expenses a business has, including: the way an organization operates (with employees, gig workers, people located in the U.S. or abroad), how employees are paid (at market, above or below), plus any employee benefits and/or long-term incentives. Understanding the people structure and strategy, including the day-to-day nuances of the business such as turnover, growth, culture and outsourcing approach, all can translate into meaningful adjustments to earnings or debt-like adjustments which is often how the transaction purchase price is determined.
More than ever, people and culture are being recognized as drivers in deal success or failure. Frequently, the talent at the organization is a key reason to do the transaction. Articulating the main reasons for doing a deal and holding those reasons up against the current strategy (or lack thereof) within each functional area often results in surprising findings. With a nod to the saying "what got you here won’t get you there," buyers not considering the intersection of people and the deal strategy are often leaving money on the table.
Often early in a transaction buyers won't know if they want to keep the leadership team. This is something that needs to be diligenced, but, understanding if the leadership team wants to stay and their individual payouts upon the proposed transaction should not be overlooked. We've worked on multiple transactions where the founder was a critical component of the business but wasn't forthcoming about their proceeds, which can be challenging for go-forward planning. Often, if leadership is critical to the go-forward business, we discuss rolling over a meaningful portion of the payout to ensure retention. When leadership won't commit within these discussions, a buyer must consider if they still want the business without the leader(s). We've seen cases where this is yes and other times where, for example, the proceeds of 43x current CEO pay actually "broke" the deal. Another possible scenario is if executives start departing post close and the organization needs a major image overhaul. In this case, truly, an ounce of prevention is worth many pounds of cure.
Additionally, when people throughout the organization will receive equity payouts, understanding their payout relative to their current compensation can provide an indication if retention post-close may be an issue more broadly.
Every deal is unique, and how employees react to the news of the deal will depend on many factors, such as the context of the deal, what will change for them, their individual experiences with deals in the past, proceeds they might receive, etc. Without a pre-signing HR diligence effort, some of these questions won't be answered, and it can be easy to miss the mark on effective communications. Further, many middle-market organizations aren't overly sophisticated in the HR/communications space, compounding the risks of rumors, unwanted turnover, lost productivity and engagement. Upon signing, buyers also have an opportunity to work with the target to craft communications related to the transaction, however, we don’t often see this opportunity seized.
#5 - Uncover synergies
HR diligence includes a thorough review of the HR trial balances and, in a carve-out, cost allocations from the parent. This review often highlights areas which may be less efficient and can be optimized with little impact on the employee experience. Additionally, economies of scale and headcount reductions can be considered along with any leveraged purchasing relationships the buyer has in place. We regularly see situations where the buyer is able to justify a higher purchase price because of anticipated synergies, and this allows them to win the bid and/or get additional financing from lenders.
#6 - Identify optimization
While linked to synergies, optimization is more about value creation than value capture. BDO advises each successful deal includes a rapid HR health check upon signing. Leveraging everything learned in the diligence phase, this check can be completed in under two weeks and co-creates a customized path forward with the HR leadership of the company along with a business plan of cost and timing to achieve. Opportunities often include things like updating the performance management plan, reviewing and updating the recruiting/onboarding process to reduce early turnover, developing a more robust training program to ensure consistency while growing, etc. While optimization can be slightly more difficult to quantify, unanimously, leaders agree when people are engaged and there are processes in place, the organization will run more smoothly and achieve more.
#7 - Avoid surprises
While a deal may appear straightforward, it is extremely rare not to have some people-related findings to note. In the middle market, there may be additional challenges due to unsophisticated HR practices or founders navigating the people side of the business as they go. It’s important to ask questions to uncover a toxic culture, work closely with legal counsel on employee claims such as harassment or wage/hour, review compliance risks related to Form I-9 (employee eligibility), the Affordable Care Act , Internal Revenue Code (IRC) 409A (deferred compensation payments) and 280G (golden parachute payments), as well as reconsider pension deficits, union pay increases and the like. In addition to the topics covered in #1-6, there is valuable visibility and context gained during diligence.
In the deal world we hear a lot of “hindsight is 20/20” and “I wish I knew then what I know now” statements, but it doesn't have to be this way. We encounter many organizations where HR was an afterthought and the result is multiple payrolls, multiple benefit programs, disparate cultures, low leadership approval, high turnover, compensation programs not meeting goals but paying out anyway, etc. During diligence many of these potential issues can be highlighted and quickly addressed, while addressing these afterwards can be messy or result in employees with deal fatigue. Additionally, ongoing changes in headcount, benefits, vendors, etc. after the deal can feel like too much uncertainty resulting in unwanted turnover. Creating a strategy early in the process and communicating that strategy to all stakeholders and employees will reduce the uncertainty and stress a transaction can create.
A wise person once said, failing to plan is planning to fail. Even a high-level review of a target's workforce can yield some surprising insights. Learn more about BDO’s Workforce in Transactions services and contact us to discuss how we can support your next transaction.