Human resouce due diligence as a valuation instrument for mergers and acquisitions

Table of Contents

Index of Tables/Figures

Index of Abbreviation

1. Introduction

2. Definition of Mergers & Acquisitions

3. Definition of Human Resource Due Diligence

4. Human Resource Due Diligence in Mergers & Acquisitions
4.1. Human Resource Checklist
4.2. Human Resource Accounting (Flamholtz/Coff)

5. Conclusion

Addendum

Notes

Human Resource Due Diligence as a Valuation Instrument for Mergers&Acquisitions

Index of Tables/Figures

Table 1: Sources of information for HR analysis

Table 2 : Examples for content of a Human Resource Checklist

Figure 1: Overview over Human Resource Accounting

Figure 2: Calculation of the Value of Human Assets

Index of Abbreviation

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1. Introduction

During 1994 and 1999 the volume of mergers increased from US$ 450 billion to more than US$ 2,240 billion, which is an indicator for increasing significance as well as increasing risk. Only 30-50% of Mergers and Acquisitions (M&A) are successful. Neglect of the factor “staff” is one of the main reasons for failure of M&A^[1].

According to a survey of the GHS Wuppertal university in 1999 the importance of HR Due Diligence in Germany ranged far behind analysis of financial, legal, tax, market, controlling corporate management aspects. Most merging companies still consider financial valuation the by far most relevant factor.

For those who did consider the factor staff – only about 37%^[2] - , HR Due Diligence was usually reduced to getting to know hard facts such as structure of Human Capital of a company, contractual regulations such as labour agreements as well as analysis of personnel costs.^[3] But the value of Human Capital contains more than the plain analysis of e.g. contracts, costs for salary and accruals for pension. Soft facts like the value e.g. by performance und know-how are neglected. Evaluation of Human Capital is especially important for mergers of companies of service industries where employees are the main capital of the firm.

During the past years research concentrated on finding a method to evaluate Human Capital. The following assignment introduces the classical Human Resource Accounting model for evaluation of Human Capital in a firm.

At first a brief introduction and definition of Merger & Acquisition as well as the Due Diligence process and the integration of HR Due Diligence is given. In the third part the ways of HR Due Diligence as they are most used in practice are introduced: 1. HR-checklists and 2. the classical Human Resource Accounting model by Flamholtz/Coff as one possible method that tries to quantify the value of Human Capital. The conclusion summarizes and evaluates the importance of HR Due Diligence in the process of evaluation of a company.

2. Definition of Mergers & Acquisitions

M&A are not absolutely clearly defined in literature. In Anglo-American literature it is often used as synonym for acquisition, merger, takeovers (friendly/unfriendly) or organizational transformation.^[4]

M&A are realised in different steps or phases. However, also number and scope of phases are not equally defined in literature. It ranges from three up to more than 5 phases.

In order to locate the realization of the HR Due Diligence process this assignment is based on the 3-phases-model :

Pre-Deal Phase – Deal Phase – Post-Deal Phase^[5]

In the Pre-Deal Phase general decisions on “make or buy” of new competencies are done and at the end the most suitable partner is selected.

In the second phase, the deal phase, actual negotiations take place, legal, tax and financial questions have to be answered, Due Diligence including HR Due Diligence are carried out and on this base the purchase price is determined. Furthermore preparations for the third phase are taken.

The last phase is the post-deal phase, in which the actual merger, integration or combination of both companies takes place.

3. Definition of Human Resource Due Diligence

Due Diligence is the gathering, analysis, and reporting of the affect of all business strategies, financials, practices, policies and procedures on the corporate business decision to merge or acquire another organization^[6]. In short, it is supposed to gather as much information as possible and analyse it regarding its plausibility^[7]. While Due Diligence is generally related to the analysis and evaluation of the financial status or tax, legal, organisational, market or product related aspects Human Resource Due Diligence is the gathering and analysis of Human Capital related information as an instrument for evaluation of a company.

While in the past M&A were mainly mergers on a horizontal level resulting in a high number of layoffs, the main focus was mainly on hard facts like period of notice or social contributions and liabilities.

Nowadays the number of M&A of service industries such as telecommunication, new media, where the main capital of a merging company relies on the employees, increases. In these cases it might be of great importance for the M&A that these employees stay in the company^[8]. Therefore analysis of staff becomes more and more important.

Decisive information for mergers are which personnel resources, which personnel costs and which key data (Kennzahlen) like labor costs the merger will be based on^[9].

Relevant information for HR Due Diligence are data on tariff agreements, labour costs, productivity ratios, employer agreements in terms of labour costs, data on the structure and organization of the company, models of working hours and their evaluation have to be considered as well as aspects on social contribution, qualification of the staff and other HR key data.^[10]

One goal is certainly determination of the value of Human Capital in regard of its impact of the price of the company.

Further goals of HR Due Diligence are the analysis of future demand on personnel, possibilities of cooperation of both HR departments as well as the development of a concept in regard of a new management structure for the next five years.^[11]

4. Human Resource Due Diligence in Mergers & Acquisitions

As employees are considered the^[12] most important capital of a firm, the Human Resource department has to be integrated into the M&A process as well. Every manager shall always keep an eye on motivation of employees of the own as well as the new enterprise as well as financial aspects in regard of staff in consequence of a merger.

Each employee that leaves a company during or because of an M&A process means loss on know-how and therefore a decisive disadvantage if the goal of a merger is not only to win market share but also to gain competencies and specific knowledge from the staff. Binding of key qualifications and talents is one of the major challenges of an M&A. The step before has to be the valuation of Human Capital.

During the Due Diligence process relevant data, documents and information have to be gathered, checked and analysed that in the last step lead to signing the contract. This phase is not easy for both sides as it discloses the inside of both companies.

Lawyers, auditors and tax experts analyse the economic situation and perspectives.

Latest at this point the Human Resource department should be integrated into the phase of Due Diligence. It should comprehensively gather all relevant data for an objective and correct evaluation of all staff related issues of the company being acquired.

Requirements for HR-Due-Diligence

A comprehensive picture of all relevant personnel data is important for a correct cost analysis.

The ideal model takes into respect three dimensions of HR^[13]:

1. Evaluation of quantitative and qualitative components: Quantitative such as personnel costs and productivity; qualitative such as creativity and know-how.
2. Aspect of time: present value of assets including e.g. accrued liabilities and its future-oriented use such as customer binding;
3. Input- and output-oriented evaluation: input such as the sum of all investments in an employee; output such as earning capacity value of Human Capital such as turnover per capita.

To reduce the a. m. aspects by one dimension means a limitation of flexibility as consequence.

Before evaluation of HR can be done, at first there has to be developed a guide that contains selected items of measurement of personnel, a guideline of the sources of data as well as their analysis.

Aim of Human Resource Due Diligence

HR Due Diligence is supposed to give answers to following questions from the personnel point of view^[14]:

1. Do we want to merge? - A HR-company profile is drawn up in order to get an accurate picture of the HR climate^[15] and identify specific key employees who need to be retained at all costs.^[16]
2. Which conditions are suitable? - Financial valuation of personnel is given in regard of four aspects: present costs of staff (analysis of personnel costs), future costs of staff (analysis of financial risk in regard of Human capital), future value of staff (HR-use-of-potential-analysis) and present value of staff (HR-value-analysis) – the latter aspect is basis for the method of evaluation of personnel in the following.
3. How is the integration process to be carried out? - Calculation of integration steps and their financial costs is done.

Sources of information

HR is an important factor regarding the success of an enterprise. Changes of employees’ work and performance after M&A will have direct impact on the cash flow. Therefore their valuation must not be neglected in the valuation of a “target”-company that one wants to acquire. In the past the main focus of Due Diligence was primarily on the demands of shareholder and lender while other stakeholders such as customers and employees were left out^[17].

Therefore besides information on balances, business strategy and market data, the company that wants to merge must also know, which personnel data including their economic relevance are basis for this merger. In order to gain all relevant data, one has to ask the right questions and do careful research especially since the phase of “openness” during M&A only lasts for a short while during the Due Diligence phase. It also takes a lot sensitivity to lay open and gather such sensitive data. Therefore immediate documentation of gathered data is recommendable^[18]. Examples for the main sources of data for an analysis of Human Resources are given in Table 1.

According to a survey of 1995 following sources of the above mentioned list are of major importance^[19]: 1.interviews with managers, 2. interviews with HR department of the “target”-company that one wants to acquire, 3. annual reports, 4. interviews with suppliers, customers and competitors, 5. interim reports, 6. banks.

4.1. Human Resource Checklist

The simplest and most common way for HR Due Diligence today are the use of detailed checklists that mainly consider aspects like quantitative questions on management and staff^[20], qualitative aspects on motivation and identification of management, salary, social contribution and incentives. They usually neglect e.g. qualitative aspects on identification and motivation of staff, qualification and potential of management and staff, possible need for reduction of staff, HR information systems, HR strategies and management concepts^[21]. Examples for content of an HR-checklist are given on table 2.

However, exclusive use of HR-checklists that primarily analyse hard facts might also allow the conclusion that HR is still considered rather risk than potential.^[22]

4.2. Human Resource Accounting (Flamholtz/Coff)

Today, there are several models for determination of the value of Human Capital. So far none has prevailed.

The classical model today is the Human Capital Accounting that has been developed in the USA by E. G. Flamholtz & Coff during the 1960s and 1970s^[23]. It calculates the future achievement potential and the replacement costs of an employee in regard of his position.^[24]

As determination of the value of Human Capital according to Flamholtz/Coff is closely linked to company evaluation methods, there will be at first a brief overview over company evaluation methods before introducing the HR-Accounting-model.

Parallels with Company Evaluation Method

For evaluation of a company one distinguishes between earning-capacity value method net asset value method.

Earning-capacity value method and Discounted Cash Flow (DCF) method are the most common methods. The first is rather common in Germany while the latter is dominating in Anglo-American countries.

Calculation of Discounted Cash Flow

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U = Value of company

Z = free cash flow ( to pay net yield demands of the investor)

k = costs of capital (demanded net yield of the investor)

They take into account investment alternatives of the buyer who could either purchase this specific company or invest somewhere on the capital market . They assume that future success determine the present value of a firm. Previous annual profit is taken as future profit surplus (nachhaltiger Zukunftsertrag). For evaluation of a company according to the earning-capacity value the present value of all future cash inflows is determined. For the DCF-method the cash flow instead of the profit is discounted.^[25] DCF- as well as earning-capacity value method are future-oriented and both take investment alternatives into consideration as well as expected return and costs of equity.^[26]

For determination of the net asset value replacement costs of all operating assets as well as intangible assets as well as sales prices of non-operating assets minus debts for the existing company are summed up. Due to the difficulty of determination of immaterial values, these are in practice usually neglected.^[27]

Due to present balance techniques HR can only be found in the earning-capacity value method. The Earning-capacity value method estimates future profit respectively cash flow and discounts it.^[28] As future profit is among others dependent on HR, HR is represented in the earning value. Earning value minus net asset value is goodwill. In order to find out the share of HR in the goodwill, one has to analyse different sources of cash inflows which sum up to the future profit or cash flow.

Determination of the Value of Human Resources

As M&A are future-orientated, Value Accounting plays an important role (Figure 1). Value of Human Resources can be defined according to Flamholtz as the discount of value of future use to the present. For its determination monetary and non-monetary evaluation can be used. While non-monetary evaluation is based on characteristics of the employee and the company, the results of monetary evaluation are quantified in terms of money. Therefore latter is important for the evaluation of a company as well as determination of its price in regard of M&A^[29].

Value of Human Assets or synonym personal replacement costs is according to Flamholtz/Coff the sum of Controlled income stream and Positional replacement costs. (Fig. 2)

Positional replacement costs are the costs that arise if the same position in a company had to be filled. It assumes that all people are completely replaceable. It measures the costs for acquisitions, development and separation for filling the same position only. These costs are calculated by the Human replacement cost model.

Controlled income streams are the costs that occur if an employee leaves the company or in other words the income that a firm would loose if a staff member left the company. It assumes that the employee is not replaceable by simply filling the position. These costs are calculated by the stochastic rewards evaluation model.

Personal replacement costs therefore are the sum of positional replacement costs and controlled income streams and this way recognizes that some aspects of a person are irreplaceable.

4.2.1. The Human Replacement Cost Model

Human replacement costs are often called “start^[30] up costs”. They consist of acquisition costs, development costs and separation costs.

Acquisition costs include all costs that are related to recruiting a person such as interviewing costs and placing him/her in the appropriate job.

Development costs include all costs for training related to the new hire.

Separation costs include costs that occur because of inefficiency or lost business related to a person leaving the company.

4.2.2. The Stochastic Rewards Evaluation Model

For the Stochastic Rewards Evaluation Model^[31] Flamholtz distinguishes between two kinds of values:

- Expected Conditional Value
- Expected Realizable Value

The expected conditional value represents the potential value of an employee, if he stayed in the company during his whole working life.

The expected realizable value of the single person takes into consideration that a staff member could leave the company any time.

Expected Conditional Value of an Employee

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Expected Realizable Value of an Employee

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The result of E(CV) would in financial terms equal the economic value. In order to determine this to the point of time of the M&A, this value has to be discounted to E(RV) and is according to Flamholtz/Coff also called “controlled value or controlled income”.

Ri can according to Flamholtz/Coff either be calculated on the basis of the price per unit of human services multiplied with the quantity of expected services or on forecast of expected earnings of a firm and allocating them between Human and other sources. Furthermore value surrogates can be used.

Similar to the DCF-method the problem of this calculation is the estimation of all figures. For companies with many employees the calculation is due to the extensive amount of data very difficult. Furthermore, determination of the discounting factor might be a problem.

Despite the problems the Human Resource Accounting Model by Flamholtz/Coff is the most comprehensive and the most developed value accounting model and therefore of importance for HRM. The advantage is that the future value of HR is discounted to the present and this way the personal replacement costs of an employee are calculated^[32].

5. Conclusion

The HR aspect is not missing in the evaluation of the company. It is indirectly integrated in the result of the DCF-method. However, it is important to calculate the share of Human Capital within the overall evaluation of the firm separately in order to get to know the share of value of Human Assets in regard to the total company evaluation and therefore pay more attention to it. ^[33]

In order to be able to calculate the value of HR, access to the relevant data is necessary. Then the appropriate approach for the company evaluation has to be found.

Today, there are several models for determination of the value of Human Capital, of which so far none has prevailed.

Flamholtz/Coff recommends the stochastic rewards evaluation model where the value of Human Capital is calculated according to the DCF-method and that to a certain extent also considers soft facts.

The importance of HR Due Diligence is undisputed. But as value of Human Capital cannot be determined comprehensively only by numbers, for all comprehensive Human Resource accounting models today, the lack of practicability of qualification and quantification especially of soft facts so far remains unsolved. Until then, the model by Flamholtz/Coff as well as the use of comprehensive checklists for analysis of soft facts certainly is an alternative.

Addendum

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Table 1: Sources of information for HR analysis

(Gut-Villa, p. 171 ; Picot, p. 289 )

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Table 2 : Examples for content of a Human Resource Checklist

(Dielmann, p. 471; Picot, p. 286)

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Figure 1: Overview over Human Resource Accounting

( Gut-Villa, p. 171)

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Figure 2: Calculation of the Value of Human Assets

( Gut-Villa, p. 173)

Notes

Adams, Barbara: Conducting HR Due Diligence in a Merger and Acquisition; in: http://www.worldatwork.org/pub/handoutscan2001/4D.pdf (4 January 2003)

Chovanec, Robert J.; McKendry, John H. : HR Issues in an Acquisition; in: Michigan Forward, 2002, 4; p. 8-10

Dielmann, Klaus: Unternehmenskauf und Human Ressourcen : Due Diligence-Prüfung. In: Personal. - München, 49. 1997, 9; S. 470-473

Felder, Rupert: Merger & Acquisition – eine Aufgabe für den Personalbereich; in: Personal 2001.3; p.156ff

Gesellschaft für Mittelstandsberatung mbH: Was ist mein Unternehmen eigentlich wert?; in: http://www.ac-mittelstand.de/leistungen/unternehmensbewertung/ (4 January 2003)

Gut-Villa, Cornelia: Human Resource Management bei Mergers & Acquisitions; Schriftenreihe des Instituts für betriebswirtschaftliche Forschung an der Universität Zürich, Vol 84; Zürich, 1997

Industrie und Handelskammer Darmstadt: Unternehmensbewertung; in: http://www.darmstadt.ihk24.de/produktmarken/produktmarken.htm?name=content&url=http%3A//www.darmstadt.ihk24.de/produktmarken/starthilfe/nachfolge/UBewertung.jsp (4 January 2003)

Industrie und Handelskammer Frankfurt am Main: Unternehmensbewertung; in: http://www.frankfurt-main.ihk.de/starthilfe_foerderung/existenzgruendung/basisinfos/bewertung/ (4 January 2003)

Jansen, Stephan A.; Pohlmann, Niko: Anforderungen und Zumutungen: Das HR Management bei Fusionen; in: Personalführung 2/2000; p. 30-39

Klaus Lurse Personal + Management AG: Erfolgsfaktoren von Fusionen / Handlungsempfehlungen auf der Basis einer empirischen Studie; in: Personal 2001, 8; p. 450ff.

Lawrey, Richard; Nossiter, Gaston: The Role of HR in Multi-Country Acquisitions; in: www.benecompintl.com/pdf/R.Lawrey&G.Nossiter.pdf; 8/02/02 (4 January 2003)

Mayerhofer, Helene: Personal als Deal-Breaker?; in: zfo 71.2002, 2, p.68-74

Picot, Gerhard [Hrsg.]: Handbuch Mergers & Acquisitions : Planung, Durchführung, Integration; Stuttgart , 2000

Wucknitz, Uwe D.: HR Due Diligence – Die Analyse personeller Wert- und Risikofaktoren bei der Unternehmensbewertung; in: Information Management & Consulting 17.2002,1

Wucknitz, Uwe D.: Bewertung von Personal in der Due Diligence; in: Personal 53.2001,12; p. 674ff.

[...]

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^[1] Wucknitz, Uwe D.: HR Due Diligence – Die Analyse personeller Wert- und Risikofaktoren bei der Unternehmensbewertung; in: Information Management & Consulting 17.2002,1

^[2] Mayerhofer, zfo 2/2002, p.70

^[3] Wucknitz 2002, 2

^[4] Gut-Villa, p. 25

^[5] Klaus Lurse Personal + Management AG: Erfolgsfaktoren von Fusionen / Handlungsempfehlungen auf der Basis einer empirischen Studie; in: Personal 2001, 8; p. 450ff

^[6] Adams, Barbara: Conducting HR Due Diligence in a Merger and Acquisition; in: http://www.worldatwork.org/pub/handoutscan2001/4D.pdf (4 January 2003)

^[7] Dielmann, Klaus: Unternehmenskauf und Human Ressourcen : Due Diligence-Prüfung. In: Personal. - München, 49. 1997, 9. - S. 470-473; p. 470

^[8] Picot, Gerhard [Hrsg.]: Handbuch Mergers & Acquisitions : Planung, Durchführung, Integration; Stuttgart , 2000, p. 285

^[9] Felder, Rupert: Merger & Acquisition – eine Aufgabe für den Personalbereich; in: Personal 2001.3; p.156ff

^[10] Felder, p. 156ff.

^[11] Jansen, Stephan A.; Pohlmann, Niko: Anforderungen und Zumutungen: Das HR Management bei Fusionen; in: Personalführung 2000, 2; p. 30-39, p. 37

^[12] Felder, p. 156ff.

^[13] Wucknitz, Uwe D.: Bewertung von Personal in der Due Diligence; in: Personal 53.2001,12; p. 674ff.

^[14] Wucknitz, Personal, 2001, 12, p. 674ff.

^[15] Chovanec, Robert J.; McKendry, John H. : HR Issues in an Acquisition; in: Michigan Forward, 2002, 4; p. 8-10; p. 8

^[16] Lawrey, Richard; Nossiter, Gaston: The Role of HR in Multi-Country Acquisitions; in: www.benecompintl.com/pdf/R.Lawrey&G.Nossiter.pdf; 8/02/02 (4 January 2003)

^[17] Gut-Villa, p. 168

^[18] Felder; p.156ff

^[19] Gut-Villa, p. 167

^[20] e.g. age, working contracts

^[21] Mayerhofer, p. 71 and Picot, p. 286

^[22] Picot, p. 285

^[23] Wucknitz, 2002, p. 3

^[24] Gut-Villa, p. 187

^[25] Industrie und Handelskammer Frankfurt am Main: Unternehmensbewertung; in: http://www.frankfurt-main.ihk.de/starthilfe_foerderung/existenzgruendung/basisinfos/bewertung/ (4 January 2003)

^[26] Gesellschaft für Mittelstandsberatung mbH: Was ist mein Unternehmen eigentlich wert?; in: http://www.ac-mittelstand.de/leistungen/unternehmensbewertung/ (4 January 2003)

^[27] Industrie und Handelskammer Darmstadt: Unternehmensbewertung; in: http://www.darmstadt.ihk24.de/produktmarken/produktmarken.htm?name=content&url=http%3A//www.darmstadt.ihk24.de/produktmarken/starthilfe/nachfolge/UBewertung.jsp (4 January 2003)

^[28] Gut-Villa, p.172

^[29] Gut-Villa, p.172

^[30] Gut-Villa, p. 178

^[31] Gut-Villa, p. 174 ff.

^[32] Gut-Villa, p.187

^[33] Gut-Villa, p.188f.