Top priorities for HR due diligence in a corporate transaction

Posted by Joseph Walker and Kenny MacDonald on June 21, 2019.

For organizations involved in a corporate transaction, understanding the HR-related impacts and potential risks from a financial, people/culture, and operational/structural perspective is vitally important to maximizing transaction value. At our Human Capital DealMakers event, held at Deloitte University a few months ago, M&A professionals gathered to discuss the areas on which HR should focus in order to uncover findings that could positively or negatively impact deal value and the ultimate success of the transaction.

Source: Deloitte Consulting LLP

Generally speaking, due diligence has historically been a financial accounting and tax exercise, with HR brought in near the end of the process or in some cases not until the deal has signed. Savvy leaders, however, realize that human capital/employee costs are often the largest and riskiest target company expenses. HR has an important role to play starting much earlier in the deal process, helping to identify potential deal breakers, material price adjustments, transaction agreement protections, and integration or carve-out issues. Based on discussions at our DealMakers event, HR leaders should focus their attention on the following priorities.

Financial priorities
1. One-time costs. Quantify employee-related one-time costs related to the transaction and confirm that these costs are appropriately considered in the investment model or included as an adjustment to the purchase price.
These one-time costs could include severance, retention, equity awards, transaction bonuses, recruiting,
non-compliance, and HR integration or stand-up costs. For example, a CEO has an employment agreement that includes a multimillion-dollar cash payment that becomes due upon a change in control, even if the individual remains employed with the company post-acquisition.

2. Employee-related liabilities. Identify employee-related liabilities that will be assumed as part of the transaction and determine the appropriate treatment within the purchase agreement. Defined benefit pension plans, existing retention payments, accrued severance, long-service leave, termination indemnities, deferred compensation programs, and accrued but unpaid bonuses, are a few examples of potential employee-related liabilities.

3. Run-rate cost changes. Estimate potential changes in annual employee-related costs that should be reflected in the financial model, including future compensation or benefit changes and HR functional adjustments due to the transaction. As an example, consider the situation where a manufacturing company, having a compensation philosophy to pay at the 25th percentile of the market, merges with a similar manufacturing company that targets the 50th percentile. In this case, HR should identify the increase (or decrease) in future compensation expense, if any, dependent on the go-forward compensation strategy of the combined organization.

People & Culture priorities
4. Cultural differences. Analyze both companies’ culture to determine potential differences that could impact integration and the ability to realize the full value of a transaction. Characteristics to analyze include decision-making style, leadership style, and the ability to change. Take, for example, a decades-old firm with highly centralized, command and control leadership merging with a new technology firm that uses an iterative decision-making process involving large groups of employees. Merging these two cultures without careful integration planning may cause increased conflict and spiked levels of employee turnover

5. Employee engagement levels. Review data to understand the level of employee engagement and predict willingness to assist in integration planning/implementation and drive the future value of the organization. An in-depth understanding will help identify any investments that may be needed to increase engagement across the organization. Understanding employee engagement levels also assists in the development of targeted communications during the integration process.

6. Retention concerns. Identify key employees, including executives, management, and staff level individuals, and understand what each will receive upon the transaction to allow for a determination regarding a retention program. For example, key individuals may receive large payouts from the transaction, especially if they own equity in the company, and there may be certain individuals that resign unless a specific retention agreement is in place along with the appropriate non-financial incentives to stay.

Structural & Operational priorities
7. Unions and works councils. Understand the dynamics of union and works council involvement. Are there multi-employer benefit plans in place? Will the works council need to be notified pre-announcement? Are there successor clauses or language requiring the agreement to be renegotiated in the event of a sale? What about agreed-upon wage/benefit increases resulting in operating restrictions? For example, consider a health care organization with 20 different collectively bargained agreements, many with guaranteed scheduled wage increases. If the Seller has not performed a financial analysis to assess the cost impact of the agreed-upon future increases, the financial projections may not accurately represent future compensation costs.

8. HR operations. Assess the HR function operations to determine potential synergies, integration priorities, and opportunities to optimize talent and costs. Consider the HR-to-employee ratio, the HR organization operating
and design model, and key HR systems and vendors.

9. Purchase agreement considerations. Evaluate HR-related considerations that are included in or should be added to the purchase agreement, including net debt items, transaction expenses, and compensation and benefits comparability requirements. For example, a Seller’s first draft purchase agreement may require compensation and benefits programs to remain the same for a total of two years after close, which would limit the Buyer’s ability to integrate the two companies for an atypically long period. The language of any Transition Service Agreements (TSAs) should also be considered to determine if the Seller Parent will provide certain services, such as processing payroll, on behalf of the Buyer for a specified period of time after closing.

For an M&A transaction to be able to realize maximum value, the HR financial, people/culture, and operational/structural areas need to be covered comprehensively, beginning with due diligence. By involving HR early, with specific attention to HR-related topics during due diligence, the HR function will also be prepared to support the organization through its transformative event and beyond.

Joseph Walker is a principal with Deloitte Consulting LLP. He has advised clients through the due diligence process on over 400 transactions in the last 10 years, splitting time between private equity and corporate strategic buyers and sellers.

Kenny MacDonald is a principal with Deloitte Consulting LLP. He has advised clients through the due diligence process on over 500 transactions in the last ten years, leveraging diligence findings to allow for post-signing value capture and creation.

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