Human Due Diligence

The strategic logic of Bank One’s 1998 acquisition of First Chicago NBD was clear. According to the Cincinnati Post, the deal would make the Columbus, Ohio–based acquirer, then the United States’ eighth-largest bank, “the dominant bank in the Midwest,” ensuring its survival in a rapidly consolidating industry. But three years after the deal, none of the 16 top executives picked to run the merged company remained on the job. One M&A firm included the deal in its list of the top ten M&A bloopers for 1999.

Bank One eventually recovered its momentum, but the acquisition reflects a common business problem. Too often, deal makers simply ignore, defer, or underestimate the significance of people issues in mergers and acquisitions. They gather reams of financial, commercial, and operational data, but their attention to what we call human due diligence—understanding the culture of an organization and the roles, capabilities, and attitudes of its people—is at best cursory and at worst nonexistent.

The most obvious consequence of making a deal without conducting human due diligence is a significant loss of talent right after the deal’s announcement. Less obvious is the problem of long-term attrition: Research shows that companies continue to lose disproportionate numbers of executives years after their merger deals have closed (see Jeffrey Krug’s Forethought article “Why Do They Keep Leaving?” HBR February 2003). For those who remain, confusion over differences in decision-making styles leads to infighting. Managers postpone decisions or are blocked from making them. Integration stalls and productivity declines. Nearly two-thirds of companies lose market share in the first quarter after a merger. By the third quarter, the figure is 90%.

That’s the bad news. The good news is that human due diligence can help acquirers avoid these problems. When they have done their homework, acquirers can uncover capability gaps, points of friction, and differences in decision making. Most important, they can make the critical people decisions—who stays, who goes, who runs the combined business, what to do with the rank and file—when a deal is announced, or shortly thereafter.

The value of addressing these issues early is highlighted in detailed interviews Bain & Company conducted with managers involved in 40 recent mergers and acquisitions. The research compared people-related practices in successful and unsuccessful deals. In the 15 deals classified as successful, nearly 90% of the acquirers had identified key employees and targeted them for retention during due diligence or within the first 30 days after the announcement. By comparison, this task was carried out in only one-third of the unsuccessful deals.

Human due diligence lays the groundwork for smooth integration. Done early enough, it also helps acquirers decide whether to embrace or kill a deal and determine the price they are willing to pay. In hostile situations, it’s obviously more difficult to conduct due diligence. But there is still a certain amount of human due diligence that companies can and must do to reduce the inevitable fallout from the acquisition process and smooth the integration (see the sidebar “In Hostile Territory”).

So what does good human due diligence actually involve? In our experience, an acquiring company must start with the fundamental question that all deals should be built on: What is the purpose of the deal? The answer to that question leads to two more: Whose culture will the new organization adopt, and what organizational structure should be adopted? Once those questions are answered, human due diligence can focus on determining how well the target’s current structure and culture will mesh with those of the proposed new company, which top executives should be retained and by what means, and how to manage the reaction of the rank and file.

Let us turn first to the question of culture. The answer is not as obvious as one would think.

Who Is the Cultural Acquirer?

In public, deal-making executives routinely speak of acquisitions as “mergers of equals.” That’s diplomatic, but it’s usually not true. In many, if not most, deals, there is not only a financial acquirer; there is also a cultural acquirer, who will set the tone for the new organization after the deal is done. Often they are one and the same, but they don’t have to be.

Consider the 2006 merger of the New York Stock Exchange with the all-electronic exchange Archipelago. In making that deal, the world’s largest bourse acquired more than just technology. Archipelago’s management team and governance structure will allow the NYSE to pull itself into the twenty-first century, transforming the closed-circle organization of powerful Exchange seat-holders into a company that sells shares to the public. The NYSE is the financial acquirer, but Archipelago is setting the cultural tone of the new company.

The big problem with saying that an acquisition is a merger of equals is that it allows management to postpone acknowledging which firm is the cultural acquirer, which makes predeal human due diligence all but impossible. Before you can evaluate potential people problems, you have to know which culture you want to end up with. Who the cultural acquirer is depends on the fundamental goal of the acquisition. If the objective is to strengthen the existing business by gaining customers and achieving economies of scale, then the financial acquirer normally assumes the role of cultural acquirer. In such cases, the acquirer will be less interested in the target’s people than in its physical assets and customers, though that shouldn’t discourage the acquirer from cherry-picking the best talent the target has to offer. The main focus of human due diligence, therefore, will be to verify that the target’s culture is compatible enough with the acquirer’s to allow for the building of necessary bridges between the two organizations.

But if the deal is intended to transform the financial acquirer’s business, then the target firm is likely to be the cultural acquirer. In Disney’s acquisition of Pixar Animation Studios, the integration goal was to protect Pixar’s talent and begin injecting that new culture into Disney’s existing organization. In cases like this, the question of organizational structure takes a backseat because the acquirer will not fold the target into its own structure; it may even do the reverse.

When deals are very large, the identity of the cultural acquirer may vary across business units. When Boeing acquired McDonnell Douglas in 1997, for instance, Boeing’s objective was to tap into McDonnell Douglas’s strong position with military customers. Boeing therefore viewed McDonnell as the cultural acquirer for the military aircraft and missile business. It created a separate unit to house both McDonnell’s operations and its own military aircraft and missile business. It gave McDonnell executives most of the key posts in that business and took other measures to protect the McDonnell culture. On the commercial side, it was another story. Boeing was more successful in serving commercial airlines, and it acted swiftly to subsume McDonnell’s commercial operation.

What Kind of Organization Do We Want?

It’s rare that two firms can be combined without making hard decisions about whose structure to adopt (should business units be based on our products or their geographies?), who should report to whom, how decisions will be made, and so on. In most cases, executives looking at a deal will have ideas about which structure they prefer, but they need to know whether the proposed structure makes sense given the organizational realities of the target.

The first issue to diagnose is whether the target has a coherent, functioning organizational structure that allows it to make and execute decisions effectively. How and where are the business units deployed? What is the reporting structure? How many levels of authority stand between the top of the organization and the front line? How is authority distributed between layers? Think of this as the “hardware” of the organization.

The second issue to address is the internal dynamics of the target, or its “software.” What process do the target’s executives use to make strategic and operating decisions? How effective are the checks and balances on the key decision makers? Where will the most significant points of friction emerge in combining the target’s functions or divisions with those of the acquirer?

To address these questions, the acquirer’s human due diligence team should begin by looking at the hard data: organization charts, head counts, and job descriptions. From this research, the team should be able to create a profile of the target’s basic organization, identify the reporting lines, lay out flowcharts that track how decisions are made and implemented, and describe the various official mechanisms for controlling the quality of decision making (board reviews, steering committees, and the like).

This data-based exercise, however, can take the team only so far. As any manager worth his or her salt knows, the organization chart reveals little about how effective a company’s structure is. In friendly deals, therefore, the human due diligence team should approach decision makers and their reports to compare practice to theory and uncover the strengths and weaknesses of the organization: Are decisions really made through the official channels? Which departments and functions are best at making decisions? The output could consist of a additional set of flowcharts diagramming the decision-making process. Clearly, this assessment is only feasible in a friendly deal—and usually only after the intention to make the deal has been announced.

The final task for the acquirer’s human due diligence team in addressing organizational issues is to take stock of the target’s assets and capabilities and determine which departments and functions possess those capabilities. This, obviously, is especially important for deals where the point is to acquire assets and capabilities. The unit of analysis at this stage is not individuals, but entire business units, functions, or technical departments. The team will begin by reviewing the roles, goals, and job descriptions of key areas of the company. What is the scope of the units’ responsibilities, and how well have they delivered? How does the quality of the output of the target compare with that of the acquirer? Team members should supplement these observations with a careful reading of the various units’ management accounts (an exercise that will overlap with financial due diligence). It may also help to approach managers at key customers directly to ascertain their perspective on where the target excels or falls down.

When Cargill Crop Nutrition acquired IMC Global to form the Mosaic Company, a global leader in the fertilizer business, the acquisition team quickly saw that the two companies’ organizations had similar structures that seemed to function well. They decided that the structure of the new company would mirror the operations and functional organization of both. With the design principles for the new organization in place, the combined company’s new CEO, who came from Cargill, set out to fill the top boxes. He conducted one-on-one meetings with the top 20 executives from both companies and solicited input from the heads of HR and the CEO of IMC Global. These interviews revealed differences between Cargill’s consensus-driven decision-making process and IMC’s more streamlined approach, which emphasized speed. Because Cargill was the cultural acquirer as well as the financial acquirer, the more consensual approach to decisions prevailed. But armed with an early understanding of the differences in approach, the CEO was able to select leaders who would reinforce this position. Cargill managers also took time to explain the benefits of their decision-making system to their new colleagues rather than simply mandating it.

How Will the Cultures Mesh?

As we’ve seen, in many deals it isn’t always obvious which firm is the cultural acquirer. Even when it is obvious, changing cultures is not simple. So it’s critical that the acquirer get a sense of the similarities and differences between two organizations’ cultures and just what the cultural transition will involve. This is so, even if the investment thesis downplays the importance of the culture.

Human due diligence efforts focused on culture have to begin with a clear understanding of what the target company’s culture actually is. The acquirer should start by looking at the business press to see what the target’s key stakeholders have to say about the matter and supplement that research with interviews with representatives from each group of stakeholders, if possible. The target’s executives can explain how they view their mission, their values, and their own cultural style. The decision-making diagnosis we talked about above is another tool the acquirer can use to identify differences in the two organizations’ processes that actually reflect fundamental cultural differences. For example, is decision making centralized or decentralized at the target company? Customers can shed light on how the target goes to market and responds to change. Competitors and suppliers can provide information on how the target is perceived in its industry. With this information, the acquirer can begin making decisions about the desired culture and put ground rules in place even before the deal is announced.

But the really useful cultural work of human due diligence starts after the deal is officially on the table. Then it becomes easier for the companies to work together openly. There’s a lot a human due diligence team can learn simply by spending time at the target. Team members can see firsthand what the company’s norms are about space, communication, meeting management, and dress—all important cultural symbols. They can talk to the company’s “heroes” and decipher what they stand for. And they can review compensation, performance management, and other systems to get an idea of the values and behavior the company promotes.

After an announcement, a company can also start applying a useful cultural assessment tool: the employee survey. In this kind of survey, employees from both companies are asked to rate their own company’s culture along a host of dimensions. They are also asked what they would like the combined company to look like in each of those categories. Along with face-to-face interviews, these survey data can reveal where friction and clashes are likely to spring up.

One leading American consumer products company we know (we’ll call it U.S. Goods) used surveys effectively for cultural due diligence. The company was considering the acquisition of a European company (Eurogoods) with a similar product line and clientele. Because the acquisition’s goal was to expand the geographic scope of the core business and achieve greater economies of scale in shared functions, U.S. Goods was both the financial and the cultural acquirer. It knew that the success of the merger would hinge on its ability to integrate Eurogoods into its own organization rapidly, which would, in turn, hinge on the cultural compatibility of the two organizations.

Working closely with their counterparts at Eurogoods, the U.S. Goods management team undertook a “cultural audit” of the two organizations. The team surveyed 28 key managers from Eurogoods, as well as 31 from its own organization, asking them a wide range of questions related to their personalities (for instance, their “desire to win” and their “external focus”), their management styles (such as their decision-making process and communications preferences), and their perceptions of organizational norms in such areas as compensation and career development. By comparing the answers, U.S. Goods was able to pinpoint cultural differences between the two organizations that might lead to leadership conflicts, talent flight, and integration breakdowns. The survey revealed, for instance, that Eurogoods had a more laid-back management culture than U.S. Goods, relying more on informal conversations and less on performance measures and organizational agility. With those results in mind, U.S. Goods formulated a plan aimed at addressing the cultural gaps and educating Eurogoods managers on the numbers-driven management ethic at U.S. Goods. It even had the Eurogoods team sign off on the plan before the deal closed.

While it’s helpful for the acquirer to take stock of data from employee culture surveys, it’s even more useful to get the managers from both companies to examine the data together in workshops. Indeed, the process of a joint review is as valuable as the data it produces. Executives participating in such workshops immerse themselves at first in the distinctions between the two cultures highlighted by the data. Then the floodgates open, and they often find they agree on many elements of the culture for the new organization, which becomes a rallying point.

Defining the values of the new culture, translating those values into specific expectations for behavior, and coming up with a plan to move both organizations to the new culture goes a long way toward understanding how each side works and what each assumes to be normal. The process also knits together the leadership team, turning its members into role models for the new culture.

Whom Do We Want to Retain?

If the financial acquirer is also the cultural acquirer, the company is likely to want to retain its own people in the top jobs. But keeping great talent from an acquired organization not only can upgrade the effectiveness of your company, it can also send a powerful message to those in the target firm about how they will be treated in the merger. What the acquirer really needs to do is get to know the management team of the target, so that it can judge who are the most talented leaders and then put the best people in each position.

In some situations, the target’s people are precisely what the deal is all about. The Chinese company Lenovo’s acquisition of IBM’s PC business, completed in May 2005, is a case in point. In fact, the board of Lenovo’s controlling shareholder allowed the company to pursue the deal if, and only if, it could recruit IBM’s senior executives to manage the merged enterprise. Lenovo’s interest wasn’t just in the top people. The company offered a job to every IBM employee with no obligation to relocate or accept reduced compensation. That meant the company could continue seamlessly on its way, with minimal disruption of engineering projects or customer relationships.

Not every company, of course, wants to retain all its target’s managers, and most will need to determine who goes and who stays. Working that out requires the same kind of detailed assessment that goes into any high-level hiring effort. Acquisition team members should gather performance reviews, interview third parties (headhunters and former executives, for instance), and assess the executives’ track records. They should probe the executives’ leadership styles and evaluate how they have dealt with difficult decisions. Most of all, acquisition team members should simply spend time with their counterparts in the target company, preferably on the target’s turf, getting to know them as individuals. The investment bankers who entertain an acquisition team at the target company’s facilities will always want team members to spend their time in conference rooms, focusing on the performance story and numbers. But every visit to a target is also a chance to get out and learn firsthand how the organization feels.

The wider the cultural gulf between two companies, the more important direct interaction with the target’s management becomes. That’s particularly true of mergers involving companies based in different countries. To take another example, a U.S. appliance manufacturer (let’s call it Atlantic Appliance) took a quite aggressive—and valuable—approach with an Asian manufacturer (Pacific Appliance) it was considering acquiring. In every key function, senior executives from the two companies got together for intensive, three-day sessions involving business reviews, strategy presentations, question-and-answer periods, and factory and office visits. Participants also dined and socialized together. On one level, the meetings were designed to help the acquirer gather information about Pacific’s processes and practices. For example, the program helped Atlantic realize that the merger integration could break down as a result of the very different financial standards used by the two companies. On another level, however, the meetings provided Atlantic with insights into Pacific’s management style and culture as well as a sense of the skills and attitudes of key managers. This analysis may well have been the primary benefit of the time spent together, becoming the basis for decisions Atlantic made about which Pacific managers to retain in top jobs and which to let go. It ensured, in other words, that the departure of employees occurred where it would do the least harm and potentially even bring benefits.

So far, our people discussion has focused on the top jobs. But in many acquisitions, the rationale is as much about the rank and file’s capabilities as the top managers’. Here, the people-assessment process overlaps with structural human due diligence. The capabilities stocktaking we described earlier tells the acquirer exactly which departments and functions house the talent the acquirer wants to retain. The acquirer can then make judgments about which individuals in those units to keep on. If it is the people in sales who are essential to the acquisition’s success, the team should talk to customers about which sales reps are the best, possibly combining this with the cultural interviews we described earlier. If the acquirer is buying research and development capabilities, it needs to bring in outside experts capable of evaluating the target’s scientists and engineers. A particularly useful tool for assessing talent at a target is forced ranking. This needs to involve some combination of HR and key senior employees who will be part of the new organization. Using performance reviews and input from senior executives, the acquisition team can usually rank every employee in the critical departments from top to bottom. These results can be cross-checked against individual bonus awards, which are often a good guide to past performance.

Once key people are identified, the acquirer must face the challenge of retaining them. Those at the top may have an ownership stake in the company, which could generate a big payout as a result of the acquisition, and they may feel they can safely leave the company or retire. Even those without an ownership stake may decide it’s time to seek greener pastures. To complicate the situation, the acquirer may want to keep some of its new employees over the long term while retaining others only for six months or a year. The best way to solve this puzzle, typically, is to put your cards on the table: Tell people exactly what you’re hoping they will do, be it stay for a short while or stay on long term, and design incentives to encourage just that. Nonfinancial rewards and aspirations are important as well. If you can convince people that they’ll now be part of a bigger, more exciting organization, they’ll be more likely to stay on.

What Will Employees Think About the Deal?

Intimately linked with the question of whom you want to retain is the question of postmerger morale. The success of pretty much any deal (except perhaps those in which the acquirer is really only after a specific physical asset or patent) depends on what the target’s employees think about the deal. Are they pleased or are they horrified to be acquired? Are they afraid? Will they actively undermine efforts to change the organization? Their attitudes will determine whether the acquirer can retain key employees, how difficult it will be to acculturate them, and whether they will accept new structures and processes.

If the deal is hostile, of course, you will not be well placed to gauge employee morale. Incumbent management at the target will be telling employees that the deal is a nonstarter and will be bad for the company. For that reason, pulling off a hostile acquisition whose investment thesis is based on the people is extremely challenging. But if the deal is a friendly one, then there’s a lot you can do to gauge and even manage the attitudes of the target’s people.

The obvious starting point is employee surveys. Most companies keep track of their employee satisfaction levels, and the results of these surveys can tell you a lot about employees’ attitudes toward their company. Do they feel that there is a free flow of information up and down the hierarchy? Do they believe that they are rewarded on the basis of merit and hard work? You can also find out which units are happy with the status quo and which are not, thereby indicating where the main communication challenges will lie. Units that are happy with the status quo may resist the changes you propose, while those that are dissatisfied may look on you as a white knight. In addition to reviewing past surveys, you can work with the target to directly survey employees about their attitudes toward your company as an acquirer. And you can monitor industry and employee placement chat rooms to see what’s being posted by your employees and by competitors.

As you build a picture of employee attitudes at your target, you will probably want to move beyond surveys to spend time with frontline employees on their coffee breaks and lunch hours, walking through plants and offices, talking with people at the operating level. When, in 2002, Johnson Wax Professional was in negotiations to buy DiverseyLever, part of the consumer goods giant Unilever, CEO Greg Lawton spent more than 100 hours talking individually with Diversey executives. From these conversations, he was able not only to identify members of a new management team before the deal was completed but also to map out a comprehensive program for communicating what the deal would mean for all stakeholders—employees, of course, but also customers, suppliers, and investors. By the time the deal was announced, Lawton and his counterpart at Diversey, Cetin Yuceulug, had prepared a joint vision and values statement, along with a video describing the new company’s direction and plans, which they distributed to the company’s worldwide staff on the day the deal was announced.• • •

Conducting human due diligence requires both sustained commitment from senior executives and the allocation of the necessary resources. It is particularly hard to do when, as too often happens, executives of a would-be acquirer are hastily responding to an opportunity that has suddenly appeared on their radar screen. There is little time even to create a cogent deal thesis to test, let alone find the time to do the kind of due diligence on people issues that a successful deal entails. But there’s another way to go about it. As we have argued, the most successful acquirers have a strategic rationale behind their deals. They build a pipeline of potential acquisitions that fit the rationale, on which they can conduct ongoing due diligence, both financial and human, before any merger opportunities ever arise (see “Building Deals on Bedrock,” HBR September 2004). With that kind of approach, acquirers usually have plenty of time and opportunity to pursue thorough human due diligence over a period of months or even years. When formal due diligence kicks off, these acquirers already know a lot about the target, including the strengths and weaknesses of its key people. They have a good idea from the outset of who is going to be the cultural acquirer in the deal, reducing the odds of misunderstandings or culture clashes. Done this way, human due diligence can turn people issues from a potential liability into a solid asset.