Investors instinctively understand the importance of conducting M&A legal and financial due diligence. However, things tend to go off the rails when it comes to performing operations due diligence. Most investors simply don’t understand the role of transaction due diligence, and the result is that most M&A failures can be traced back to ineffective transaction evaluation. Legal and financial due diligence is carried out to determine the legal and financial status of a business at a given time, usually the day a deal is closed. Operations due diligence, on the other hand, determines the company’s ability to sustain its operations over time. Question: Are there potential operational risks that could cause future business failure? Investors rely on their attorneys and CPAs to perform their legal and financial due diligence, but they often try to perform trade due diligence themselves rather than involve someone with experience in risk assessment. Worse still, they do partial risk assessment by looking at management, sales or strategy etc. but they fail to assess the entire company.
The recent bankruptcy of the solar company Solyndra has now become the symbol of unsustainable companies. Without delving into the policy of the bankruptcy or all the possible reasons for the failure, it is fair to say that investors in Solyndra, including the US government, did not effectively assess the operational risks that could affect the ability of Solyndra to sustain its operations. .
The following are just two examples of the operational risks Solyndra faced. First; Former employees have publicly stated that they were throwing away up to $100,000 worth of faulty solar cells each day. If this is true, effective operational due diligence should have identified the high cost of quality as a potential risk to business sustainability. Identifying that risk would have allowed investors to insist that a mitigation plan be put in place to reduce or avoid these costs. Second; as part of its marketing plan, Solyndra was looking for a proprietary product design. As the price per watt of standard solar panels began to fall, particularly those made by its Chinese competitors, Solyndra was unable to make corresponding reductions in the price per watt of its proprietary products that would allow them to remain competitive. The inability of Solyndra’s products to compete has been attributed to the commodification of standard panels and unfair competitive practices by the Chinese. However, the reasons for the bankruptcy are not important to this discussion. Effective operational due diligence would have identified operational risks and their potential impact on the sustainability of the business.
We can assume that Solyndra’s investors had a sufficient number of lawyers and accountants. However, neither the quality risk nor the competitive risk in these examples would have been apparent in legal or financial due diligence and effective operational due diligence was never conducted.
Unfortunately, just as many investors misunderstand the role of due diligence in operations, many companies still do not understand the importance of implementing a formal risk management program and are reluctant to provide the funds for risk management activities. Solyndra should have identified its own operational risks and developed mitigation plans to avoid them. Businesses that manage their risk improve their sustainability. If it’s important for investors to perform risk assessment as part of their due diligence, isn’t it also important for a company to perform proactive risk assessments on an ongoing basis?
With the release of ISO 31000:2009 (Risk management principles and implementation guidelines), some companies are beginning to implement risk management programs in earnest. Unfortunately, even in these businesses, risk managers often have trouble justifying the funds to support their activities because senior executives have trouble justifying the cost of the program because it’s hard to measure the benefits of increased sustainability.
An effective risk assessment, whether conducted by an investor during the M&A process or as a proactive self-assessment by a company, should assess risk across all of the company’s operations. It is not enough to say that we look at the management team or the sales department and so on.
