Investors instinctively understand the importance of performing legal and financial M&A due diligence. Things tend to come off the rails though when it comes to performing an operations due diligence. Most investors simply don’t understand the role of operations due diligence and the result is that most M&A failures can be traced back to an ineffective operations assessment. Legal and financial due diligence are performed to determine the legal and financial status of a business at a point in time, typically the day a deal is closed. Operations due diligence on the other hand is determines the ability of the business to sustain its operations over time. It asks: Are there potential operations risks that could cause a future failure of the business? Investors rely on their attorneys and CPA’s to perform their legal and financial due diligence, but often attempt to perform the operations due diligence themselves instead of involving someone with risk assessment expertise. Worse, they perform a partial risk assessment by looking at management or sales or strategy, etc. but fail to assess the entire enterprise.
The recent bankruptcy of the Solyndra solar company has now become the poster child for un- sustainable businesses. Without delving into the politics of the bankruptcy or all of the possible reasons for the failure, it is fair to say that the investors in Solyndra, including the US Government, failed to effectively assess the operations risks that could impact Solyndra’s ability to sustain its operations.
The following are just two examples of the operations risks Solyndra faced. First; former employees have stated publicly that they were throwing out as much as $100,000 worth of defective solar cells each day. If this is true than an effective operations due diligence should have identified the high cost of quality as a potential risk to the sustainability of the business. 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 their marketing plan Solyndra was pursuing a proprietary product design. As the price per watt for standard solar panels began to drop, particularly those manufactured by their Chinese competition, Solyndra wasn’t able to make corresponding reductions in the price per watt of their proprietary products that would allow them to remain competitive. The inability of Solyndra’s products to compete has been attributed to commoditization of the standard panels and to unfair competitive practices by the Chinese. The reasons for the bankruptcy are not important to this discussion though. An effective operations due diligence would have identified the operations risks and their potential impact on the sustainability of the business.
We can assume that the Solyndra investors had a sufficient number of attorneys and accountants. Neither the quality risk nor the competitive risk in these examples would have been apparent in a legal or financial due diligence though and an effective operations due diligence was never performed.
Unfortunately, just as many investors misunderstand the role of operations due diligence, many businesses don’t yet understand the importance of implementing a formal risk management program and resist providing the funds for risk management activities. Solyndra should have identified their own operations risks and developed mitigation plans to avoid them. Businesses that manage their risk improve their sustainability. If it is important for investors perform a risk assessment as part of their due diligence, isn’t it also important that a business perform proactive risk assessments on a continuing basis?
With the release of ISO 31000:2009 (Risk Management Principles and Guidelines on Implementation) some businesses are starting 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 improved sustainability.
An effective risk assessment whether performed by an investor during the M&A process or as a proactive self assessment by a business must assess risk across all operations of the business. It is not sufficient to say we looked at the management team or the sales department, etc.