Investors conduct all types of due diligence to uncover skeletons in the closet. Legal due diligence can uncover outstanding lawsuits; cultural due diligence can explain high turnover rates; IT due diligence can root out any incorrect patent filings or licenses.
But what type of due diligence uncovers future conflicts with the current owner-operator?
As financial sponsors partner with business owners, alignment between the two parties — especially regarding the future of the business — is critical to a successful transaction.
“One of the most important things we do when speaking with a business owner is to ensure that we have an understanding of their business values and the end-result of the desired transition,” said Kevin Coughlin of Coughlin Capital. To address these issues, Coughlin Capital employs a type of ‘values due diligence.’
According to Coughlin, misaligned values can threaten the success of an investment. “Our values, with regard to how the business will be run, need to align. If they do not, it can cause significant headaches and hurdles in the future. If the values are clearly conflicting, it’s a non-starter.”
As a result, Coughlin likes to conduct values due diligence in addition to the regular financial, legal, and operational diligence. Instead of relying on regular management meetings, it is advisable to have direct and clear conversations around values. “To flush out these [value-related] issues, we sit down and discuss the owner’s plan,” he explained. “We want to really understand how the owner sees the future of the company.”
When should it happen?
“This conversation can happen at any time before the closing of the deal — but the earlier in the process, the better,” said Coughlin. “For a successful deal, there still needs to be a level of trust, and the earlier the conversation, the easier it is to develop the trust and have a sincere connection around business values.”
However, don’t have the conversation too early. Prematurely discussing these values can undermine the entire purpose of the conversation. Coughlin explained, “If you tell them you want to sit down to talk about business values, they won’t do it unless they think a transaction is likely.”
The ideal time for the conversation is “sometime after an LOI, but before the closing of a deal.”
What should be discussed?
This diligence of values needs to be more than another management meeting, and it shouldn’t be mere lip service. Candor and honesty are helpful in ensuring the relationship starts on the right foot. “There are certain changes in governance and operations we want to implement and there needs to be a base level of trust between the business owner and us. As a result we need to buy into each other.” Building that mutual trust is critical to ensuring optimal post-transaction efficiency.
To gauge the mutual respect, Coughlin likes to discuss topics like “how we will treat each other as owners, how customers will be treated, how employees will be treated, how vendors will be treated, how the day-to-day operations will be run, etc.”
He added, “While the owner’s business values are not a reason to invest in the business, they can be a reason to walk away.” As a matter of fact, they have been. “We walked away from one deal in the past two years for business values-related reasons. We had the conversation and it became clear right away that there wasn’t a match. We would prefer to walk away from a good deal than do a deal that would fail.”
Help stand out
The values conversation, in addition to helping prevent future conflicts, can also help you stand out from the competition. “I really believe that most of these retiring entrepreneurs want more than a simple check; they want a real transition with real mentorship…they want succession,” previously explained Benjamin Gerut of the Kuzari Group.
He continued, “Buyers must care about the employees. After working with many of these people for years or decades, it is hard for me to imagine an owner being comfortable simply selling to a PEG without any comfort as to the long-term future of the company and its human resources.” By having these explicit conversations, you can help demonstrate to owner-operators that you are dedicated to having parallel values.