M&A Dealmakers Intensify Focus On Founders’ Background Checks To Help Mitigate Risk

March 21, 2024 – In the VC world, it seems that for every startup that fulfills its unicorn potential, there are countless others that flame out amid high-profile controversy. Often, those flameouts are accompanied by pointed media commentary asking how the signs — so obvious in hindsight — could have been missed. This has led to increased scrutiny by venture capital firms’ decision-making and risk-management teams.

VC investors, however, are not alone in judiciously doubling down on due diligence prior to investing. Private equity operators and strategic buy-side teams are also paying closer attention to critical pre-acquisition due diligence to set the foundation for a seamless process, and often that means focusing on the talent that comes along with the deal.

“Getting human due diligence right is surfacing more than ever as a critical component of every M&A process,” said Michael Karran, a managing director of Mintz Group, a corporate investigations firm that gathers information before hiring, before transactions, during litigation disputes and after frauds, all over the world.

According to recent reports from Pitchbook, Bain & Company, McKinsey & Co., Goldman Sachs, Morgan Stanley, Deloitte, EY and a host of other global consultancies keeping a keen eye on M&A, competition for deals is set to rise. According to Mr. Karran, the potential for compressed deal cycles that give less time for not just formal diligence processes, but for simply developing a comfort level with founders and management teams, is real.

Investing in Leadership

“It’s long been an axiom in the investment world that you’re not so much investing in a startup or a mature business as you are investing in the leadership, judgment and integrity of its management,” noted Mr. Karran. In the case of a startup, he said, this axiom “is reinforced by the fact that its financials and projections, are by definition, less robust than that of a company with a developed product and a track record of meaningful revenues.” There is, in other words, less material on which traditional due diligence can be conducted.

These constraints make comprehensive background checks on founders and key management more important than ever. If done correctly by an experienced team of investigators, comprehensive evaluations can be more than a box-checking exercise — they can provide a pathway for a deeper understanding of the management team.

Related: 2024 M&A Outlook: PE Comes Off the Bench

These insights, said Mr. Karran, can be useful not just when evaluating the investment, but in helping build a productive relationship with founders and management post-close, when the focus turns to integration.

Looking for Red Flags

Background checks conducted by Mintz Group of startup founders and key management typically include an exhaustive checklist of items, including involvement in any civil, criminal, tax, or bankruptcy litigation; enforcement actions taken by regulators or inclusion on global sanctions and watchlists; controversies or other risk-relevant information in the media and on all corners of the Internet, including through AI and manual searches for any contentious publicly available content; details regarding the leadership team’s track record and performance of other business ventures they have been involved in; background information about the company in question, including details to compare against the material provided by founders or management team to the deal team; verification of prior employment and credentials, including degrees and professional licenses; and controversies associated with prior businesses (which may not necessarily name the leaders).

Pitchbook Market Data Points To Uptick In M&A Deal Activity
At the two-year anniversary of an all-time peak reached in 2021, the global M&A market turned in its second weakest year in exactly a decade. With total deal value sitting right around the $3 trillion mark, 2023 closed with a 15.8 percent decrease from 2022. However, according to Pitchbook’s latest Annual Global M&A Report, 2024 may be set for an explosive trend reversal.

Pitchbook points to a slowing decline as evidence that the worst may be behind us. The decline in deal value was much steeper two years ago than it was in 2023, where 2022 saw deal value shrink by 23.4 percent. Meanwhile, Q4 2023 sported the best volumes since Q2 2022, with total deal value increasing 6.5 percent from Q3 2023. This represents a positive sign that trends are beginning to shift in the right direction.

For VCs specifically, Mintz will seek to identify relationships that founders have had with other investors and venture capital firms; instances where the founders may be involved in many ongoing projects; and whether the founding team has had experience working together in the past.

Related: 2024 M&A Dealmaking Outlook, With An Eye On Human Capital Markets

Depending on the nature of what is uncovered, investigators may suggest expanding the scope of the background check to gather further context and resolve uncertainty. “When background checks identify potential red flags, investment teams can then assess the findings and factor them into their overall decision-making on the deal,” said Mr. Karran.

It should be noted, he added, that background checks merely uncover information and context — “how to act on the findings is left to the buy-side investment team,” he said. Because of this, those vetting the investment should go into the process with a sense of what their deal-breakers are.

Human Due Diligence

The extensiveness of Mintz Group’s checklist suggests that background checks have a usefulness that extends beyond verifying information and identifying potential warning signs.

“The information uncovered also provides useful insight that can help M&A teams better guide the management team post-close,” said Mr. Karran. For example, the management team’s history (or lack thereof) of working together may not constitute a red flag, but it may influence the type and level of oversight the team should have.

In an environment where successful M&A is not a given, nothing can be left to chance. Bain & Company surveyed managers involved in 40 M&A deals. In 15 that Bain classified as “successful,” almost 90 percent of the acquirers reported identifying essential talent for retention during due diligence, typically before the deal had closed. In the remaining unsuccessful deals, acquirers did not identify essential talent.

While these statistics make the value of retaining essential talent clear, good human due diligence identifies more than just key people. For example, it can be used as an important barometer for acquirers to glean an accurate assessment of cultural fit. Data from 1,400 M&A deals, collected by Mercer, concluded that cultural issues were the reason that 420 of them, or 30 percent, failed to meet their financial targets.

Drew Seaman is a managing director at Hunt Scanlon Ventures. He is responsible for co-managing the firm’s investment portfolio of executive search, talent acquisition, private equity, and investment firms. In addition to sourcing new opportunities and managing the firm’s current investments, Mr. Seaman leads the technical aspects of client engagements, including valuation and financial analysis and the preparation of investment marketing materials.

Reprinted from with permission from ExitUp!

Contributed by Scott A. Scanlon, Co-CEO, Drew Seaman, Managing Director – Hunt Scanlon Ventures