How to Prepare for HR Due Diligence in M&A

Have you ever sold a car? Your buyer probably wanted to take it for a test drive. After doing a quick lap around your neighborhood, they’ll have checked your engine belts were updated, no oil was leaking underneath, and you didn’t have any strange dents in the car body. 

Selling a business is often similar.

Although your buyer can’t take over as CEO for a day, they will inspect your business – or hire someone to inspect for them, much like hiring a skilled mechanic to look under the hood. 

This pre-acquisition inspection, called due diligence, covers every aspect of your business including legal, finances, technology, and even human resources (HR).

In HR due diligence, buyers evaluate things like how well your HR team does its job, whether or not you follow local employment law, and if your company culture is an asset or a liability. 

Preparing for HR diligence can be challenging since it deals with hard-to-quantify elements like people and culture. Below, we explain what buyers typically examine during HR due diligence and how to prepare for it.

What Are Buyers Looking For During HR Due Diligence?

One of the big three consulting companies, Deloitte, describes what it looks at when performing third-party HR due diligence for buyers on its website. If private equity or a large corporate buyer courts your business, you can likely expect a similar process with buyers inspecting:

• Compensation and benefits – Your different types of compensation (payment, stock options, etcetera) packages, policies and procedures, and benefits
• People and culture – Employment structure, demographics, office culture, and independent contractor agreements
• Labor relations – Regulatory issues and risks associated with your management practices. For example, mishandling of sensitive employee data

Now let’s walk through the steps you must take to pass these checks.

How to Conduct an Internal HR Audit 

If you haven’t reviewed your internal policies recently, you might discover glaring HR or policy errors. These can be minor differences in employee contract formats to security risks in your HR data system. 

Before trying to sell your business, conduct an internal HR audit to understand how robust your people policies are and where you need to improve. 

1. Review all of your HR policies, practices, and procedures. All of your policies should be coherent, cohesive, and known by employees. For example, if your company policy is to give two weeks of sick leave per year, ensure employee contracts match. A quick way to test if your policies are clear is to ask your employees about them.

2. Identify anything that could raise concerns during the due diligence process. Common policy areas and their issues include:
   1. Employment contracts
      1. Ambiguously worded contracts
      2. Poorly defined termination clauses
      3. Poorly-worded or nonexistent non-competition clauses.
   2. Employee classification
      1. Full-time employees classified as independent contractors to avoid paying payroll taxes and benefits. 
      2. Employees doing large amounts of work outside their job description.
   3. Compensation and benefits
      1. Unclear wording in contracts about pay and benefits. For example, what happens to employee stock options in the case of a firing?
   4. Recruitment and selection
      1. Poor communication during the recruitment process 
      2. Lack of diversity in hired applicants
      3. A long recruitment process
      4. Inaccurate job descriptions
   5. Disciplinary procedures
      1. You don’t discipline equally across all employees
      2. No clear discipline process
      3. Disciplinary action is often inadequate
   6. HR Systems
      1. Overly-complicated HR data systems
      2. Incorrect data storage that results in record losses or regulatory issues

At a glance, this list covers most of the things you’ll need to prepare in an internal audit. Now let’s go into a bit more detail.

HR Due Diligence Checklist

Running a business, you can quickly accumulate a massive list of documents and policies that buyers want to see before buying. Below is a long list of HR items you should locate, check, or draft for your business before undergoing HR due diligence. Much of this is based on a sample checklist I found online from an HR services consultancy.

This list is not exhaustive and is tailored to businesses in the US. Research specific local laws and regulations your business needs to comply with.

Agreements and Contracts

Agreements and contracts include any signed legal document between your business and another party. They include things like:

• Employee contracts
• Labor contracts, union agreements, and collective bargaining agreements (you’ll likely not need to worry about these at a startup)
• Non-compete contracts (agreements preventing employees and contractors from working with competitors)
• Confidentiality statements and agreements
• Contracts of preemptive rights – For example, a contract granting the right for existing shareholders in a corporation to purchase newly issued stock before it is offered to others.

HR Policies

HR policies govern your employees and any other aspect of your workplace like your office or online communication channels, including your:

• Absenteeism policy
• Disciplinary policy
• Personal, maternity and sick leave, and bereavement policies
• Grievance and damage control policies
• Codes of ethics and conduct
• Safety policy
• Media relations policies
• Third-party confidential information policies
• Equal employment and anti-discrimination policies

Compliance Policies

Compliance policies describe your company’s dealings with the law. This section changes depending on your location and governing jurisdiction. Documents include:

• Litigation or judgments in which your company was involved directly or indirectly and settled within the last five years
• A list of all pending or threatened litigation, inquiries, or investigations
• All consent decrees (resolved disputes that don’t admit liability for either party), judgments, injunctions, orders, and arbitration findings to which your business is bound
• A list of all employees affected by disability legislation
• A history of all sexual harassment accusations, charges, and convictions in your business from the past five years
• Your company’s history of unemployment and workers’ compensation claims
• Proof you comply with the fair labor standards act (the law requiring a minimum wage for employees and time-and-a-half pay for overtime)

Benefits Policies

Benefits policies establish how you pay employees and give them other perks like health insurance. Documents could include:

• Employee health insurance plans
• Employee monetary compensation plans and their schedules
• Other types of non-monetary compensation for employees
• Bonus or profit-based incentive programs and lists of employees who have received bonuses, amounts given, and reasons for them.
• Severance plans and packages
• Pension plans and other retirement plans
• Proof of compliance with the Employee Retirement Income Security Act (ERISA), the law establishing minimum standards for pension in the US (or equivalent programs).
• Information on your company’s Consolidated Omnibus Budget Reconciliation Act (COBRA) compliance – a program allowing some employees to retain insurance benefits after leaving

You now know what needs to change (or what you need to add) before entering HR due diligence with a buyer. If you have the funds, get audited by a third party. A knowledgeable consultant can help you prepare the documents and policies you need in your particular state or country.

Organize Your HR Records

Now that you’ve identified and resolved issues with your policies and HR system, get everything ready for inspection. You want to help a potential buyer check out your HR department as quickly as possible since speed is crucial in most deals.

In addition to all of the above documents, create summarizing documents like those listed below:

• Prepare a list of all the executives and employees with significantly higher compensation.
• Create a document with basic employee demographics like:
  • Titles
  • Positions
  • Salaries
  • Age
  • Locations
  • Genders
  • Skills
• Collect HR metrics like:
  • Headcount
  • Average tenure
  • Turnover
  • Average time to fill new positions
• Provide summaries of performance review schedules and structures.
• Summarize HR and employee-related expenses.
• Prepare to send your recruiting and onboarding process documents including copies of interview guides or templates and new-hire orientation practices.
• Include an audit of your Human Resource Information System (HRIS) or employee database. For example, find out who has access to it, if the data is accurate, and if your security measures comply with local regulations.
• Provide copies of payroll documents for all employees.

These documents will allow you to provide relevant information quickly during due diligence. We recommend you file all of these documents and proofs of compliance in your data room along with your policy documents.

Preparing for HR Due Diligence

Now that you’ve collected and updated your policies and documents, prepare for buyer interviews. HR due diligence is more than just sharing documents – the buyer might also talk to people like your HR managers, current employees, and even vendors.

Ensure your team understands your policies and key parts of your company culture or risk leaving a bad impression.

Define Your Company Culture

Especially if you have employees, try to outline a company culture before your sale. A company culture statement helps buyers identify how to onboard your team. Your culture statement characterizes your entire organization and provides a framework for understanding what motivates your team and how they expect to do their job.

Even if you haven’t given it much thought, you likely have more of a company culture than you think. What principles have you used to do the work you’ve done? What principles do you think your team should follow down the line? Jot those down and send them out to your team.

Why Is Company Culture Important?

How you work with your employees is one of the most important aspects of your business to buyers.

Loyal, hardworking, and motivated employees are incredibly valuable. In the best cases, they transcend the company that hired them. Ever heard of the Paypal mafia? This group of C-suites and engineers from Paypal not only made the company a massive success, they went on to found some of the most successful tech companies of the early 21st century. Many credit Paypal’s unique work environment for fueling their drive and ambition.

Buyers want to harness a team of superstar employees like the Paypal Mafia or tap into a business environment to create successful employees like them. If your business has a chance of producing one, it makes an acquisition that much more desirable.

But buyers can struggle to retain seller talent. PwC’s 2020 Mergers and Acquisitions (M&A) integration survey found a large reduction in respondents reporting “significant success” in employee retention – dropping from 56 percent in 2010 to just 10 percent in 2019. As a result, many institutional buyers pay much closer attention to HR and employee culture today.

Company cultures are both rigid and organic. They are formed by your aspirations for what you want for your company and evolve as your workforce grows.

While you might not see the point of worrying about one if you’re an early-stage business, lay down some guiding principles from day one or before an acquisition. This will give your buyer extra insight into how you’ve structured your HR policies and who you’ve hired.

Examples of Company Culture Statements

There’s no need to stress about defining your culture when experts have already created some amazing examples. Here are a few guiding principles and culture statements from three companies known for their unique work environments and high-quality products.

Google

Google has been a frontrunner in the tech world for years both due to its innovation and company culture. Much of their cultural success comes from being specific about their values. Besides their famous “Don’t be evil” guiding principle, they also promote the following:

• Focus on the user and all else will follow.
• It’s best to do one thing really, really well.
• Fast is better than slow.
• Democracy on the web works.
• You don’t need to be at your desk to need an answer.
• You can make money without doing evil.
• There’s always more information out there.
• The need for information crosses all borders.
• You can be serious without a suit.
• Great just isn’t good enough.

Apple

Today, Apple has numerous value statements on its website but its ultimate culture statement was coined by Steve Jobs when he returned to the company in 1997 to save it from bankruptcy. He said: “We believe that people with passion can change the world for the better.”

He also laid out a list of guiding principles for Apple’s company culture back in 1981:

• One person, one computer.
• We are going for it and we will set aggressive goals.
• We are all on the adventure together.
• We build products we believe in.
• We are here to make a positive difference in society, as well as make a profit.
• Each person is important; each has the opportunity and the obligation to make a difference.
• We are all in it together, win or lose.
• We are enthusiastic!
• We are creative; we set the pace.
• We want everyone to enjoy the adventure we are on together.
• We care about what we do.
• We want to create an environment in which Apple values flourish.

While some of these values are admittedly vague, this lets them be interpreted broadly when applied to new challenges decades in the future. Even after Jobs’ death, Apple has followed many of these principles as it remains the frontrunner in new consumer hardware.

Costco

Retail wholesaler, Costco, is known for its exceptional customer service and employee satisfaction. Like the following two companies, it keeps the vision statement simple for both customers and employees. For customers, it promises to, “Continually provide our members with quality goods and services at the lowest possible prices.”

Internally, it states it will:

• Obey the law.
• Take care of our members.
• Take care of our employees.
• Respect our suppliers.

You don’t need to write a novel to define your company culture. Some of the biggest names make do with a simple but specific rulebook. During regular meetings with employees, update them on your HR policies and company culture. Have a team meeting where you explain exactly which points about company culture and policies everyone should remember should an auditor contact them.

Once you have all the proper documents in order, a culture statement worthy of a sale, and your entire team on board, you’ll likely pass your HR due diligence quickly.

Seek Professional Advice For M&A HR Due Diligence

As we mentioned, if you go through all of the above and still feel unprepared for HR due diligence, consider engaging an HR consultant or legal professional to assess your HR practices and policies. They’ll identify areas of improvement and guidance on how to mitigate risks.
Sign up for a free seller account on Acquire, or contact our team to see exactly how we can prepare your business for acquisition.

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