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Jul 1, 2006 (Vol. 26, No. 13)

Pre-Deal Leadership Due Diligence a Must

Management IS the Most Critical Factor in Creating and Destroying Value

  • Scott Whitston was a shining star from the beginning of his career in biochemistry. He graduated at the top of his class and landed a coveted R&D job at a major biopharmaceutical company. Driven, Scott was an early standout at the lab where he worked to discover new diagnostic markers for neurodegenerative diseases.

    While passionate about the science, Scott had also always had a strong entrepreneurial bent and eventually became restless. Using most of his savings, Scott recruited a team of post-docs to found a biotech start-up called Ivy Diagnostics, which focused on developing new screening tools for Alzheimer’s disease.

    The new firm ran off of personal cash, bank loans, NIH grants, and free labor for a time and made rapid progress with its research. Needing venture money to further develop and commercialize the company’s products, Scott and his team wrote a business plan and began shopping for capital.

    XG Capital Partners, a venture capital firm specializing in early-stage biotech companies, read the plan and was immediately impressed. Over the next few weeks, XG Capital completed a rigorous evaluation of Ivy’s research and finances, as well as the market opportunity and competitive landscape for the company’s planned products. Concerned about competing VCs showing interest in the company, XG Capital rushed to commit $25 million in growth capital in exchange for a majority interest in Ivy Diagnostics.

    After receiving the influx of money, the nature of Scott’s job as CEO quickly changed. He shifted much of his focus from the science to finding and recruiting the best people for the company. Scott had always found the lab to be an oasis. Now, he was dismayed at the amount of time he was spending away from the lab. He began to bristle at what he perceived as constant meddling and unwanted guidance from XG.

    As Scott’s mood darkened, his micromanaging and increasingly condescending attitude toward subordinates began to wear on the other scientists. The pressure on Scott from XG escalated as projects fell behind deadline or stalled completely, and then Scott’s former employer announced pending trials of a competitive product.

    Ivy Diagnostics entered crisis mode, as it was many months away from making such an announcement. Finally, the partners at XG Capital made the decision to bring in a new CEO. Rather than demote Scott to a research position, it was decided that he had burned too many bridges, and he was terminated.

  • Assessing Leadership Capabilities

    While this situation is fictional, all too often critical errors are made by venture capitalists and other investors or acquirers around assessing leadership capabilities. This is a major challenge faced by strategic or financial investors considering whether or not to invest in or acquire a company and its leadership team.

    During the IPO boom of the late 1990s, investors could count on the bull market for public stock offerings to help them extract quick and large profits from even poorly managed portfolio companies.

    However, today’s tougher market has seen a decline, or at least a delay, in exit opportunities for these investors. According to Jay Ritter, an economist at the University of Florida, in 2000 the median age of companies that went public during 1999 and 2000 was five years.

    For the period between 2001 and 2005, the age doubled to ten years. This means investors are more dependent than ever on their portfolio company management teams to lead these organizations for the long-termrelying on these managers to steer the company through more stages of growth and change.

    Making a wrong investment decision around management, whether it’s for a start-up or a multibillion dollar buyout, leads to millions of dollars in losses. When one takes into account vested management options or stock, severance, and executive-search costs, not to mention the loss of morale, momentum, and growth opportunities for the company, poor decisions about company leadership can be devastating.

    Of course, if asked, most investors would say that the quality of the management team is a critical factor when evaluating an opportunity, and poor management is most often the reason cited when expected investment returns fail to materialize.

    Yet, ironically, many private equity investors spend less time analyzing management as part of formal due diligence than on other issues. Why? Probably because it’s time consuming, and they believe reliable metrics are hard to come by. Also, while comfortable analyzing balance sheets and market shares, some investors find human capital issues rather fuzzy. As a result, many private equity professionals rely largely on routine background checks and gut instincts in assessing executives.

    Fortunately, investors are increasingly discovering expedient and more rigorous options for assessing portfolio company leadership. According to Daniel Jones, Ph.D., an executive assessment and development expert and WJM Associates faculty member, "It behooves venture capital investors to make management due diligence a priority. Leadership factors that are critical to growing a company and achieving the sought-after ROI are in fact measurable prior to an investment or acquisition. Leaders with or without the needed competencies can be identified using 360-feedback techniques and other instruments."

    Administered by a skilled organizational psychologist, a preinvestment evaluation can be a powerful tool for investigating an executive’s:

    • Capability to successfully lead the company during transition to a new configuration (e.g., small private enterprise to larger public company, division of large organization to stand alone company, pre- to post-merger)

    • Cultural fitboth within the portfolio company and in partnering with the investor firm

    • Interpersonal adaptability and openness to consultation and advice

    • Sensitivities to ethics, laws, and regulations

    • Communication skills and style

    • Vision capability

    • Emotional intelligence

    • Personality

    "In addition to being an invaluable component of a thorough due diligence process, this type of pre-deal evaluation provides the investor with a clear understanding of the development needs of key personnel prior to investing or purchasing and allows the investor to build these needs into performance parameters from the start," says Dr. Jones.

    David Cooper, another WJM faculty member and founding partner of Cooper Limon, offers the unique perspective of being both an accountant and a psychologist. "The leadership assessment process shouldn’t be an exercise in psychological data dumping. It must provide information that is focused, practical, and relevant in the context of the deal and the real-life business challenges being faced. The risks facing the company must be carefully identified, and the strengths and weaknesses of each member of the leadership team should be assessed against these risks."

    As we’ve seen with our fictitious case study, the skills necessary to successfully lead a company can shift dramatically with the infusion of growth capital or in the midst of being acquired or merged with another organization. Thoroughly and accurately evaluating a senior management team’s competencies (in the context of the likely changes and pitfalls unique to each transaction) represents a crucial component of pre-deal due diligence. Given the fast-paced and hectic workloads of many investment professionals and the millions of dollars at stake in these transactions, it often makes sense to make the comparatively small investment in bringing in objective, professional expertise to assist with these critical assessments.



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