Investors instinctively understand the importance of performing legal and financial due diligence on mergers and acquisitions. However, things tend to go off the rails when it comes to conducting operations due diligence. Most investors simply do not understand the role of deal due diligence and the result is that most M&A failures can be traced back to ineffective deal evaluation. Legal and financial due diligence is carried out to determine the legal and financial status of a company at a given point in time, usually the day a deal is closed. Operations due diligence, on the other hand, determines the company’s ability to maintain its operations over time. Question: Are there potential operational risks that could cause future business failure? Investors rely on their attorneys and CPAs to do their legal and financial due diligence, but they often attempt to do the due diligence on trades themselves rather than involve someone with underwriting experience. Worse, they do a biased risk assessment by looking at management, sales, or strategy, etc. but they fail to evaluate the entire company.
The recent bankruptcy of solar company Solyndra has now become the poster child for unsustainable business. Without delving into the politics of bankruptcy or all the possible reasons for the failure, it is fair to say that Solyndra’s investors, including the US government, did not effectively assess operational risks that could affect Solyndra’s ability to 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 competitor, Solyndra was unable to make the 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 bankruptcy are not relevant 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 the Solyndra investors had a sufficient number of lawyers and accountants. However, neither quality risk nor 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 conduct risk assessment as part of their due diligence, isn’t it also important for a company to conduct 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 is difficult to measure the benefits of increased sustainability.
An effective risk assessment, whether conducted by an investor during the mergers and acquisitions process or as a proactive self-assessment by a company, should assess risk across all company operations. It is not enough to say that we look at the management team or the sales department, etc.