When bad things happen to good mergers.

More than two-thirds of acquisitions fail. In fact, some out- comes may surpass mere failure and qualify as a genuine disaster. Just ask Novell, which bought WordPerfect for $1.4 billion and sold it 18 months later for $1.2 million. Then there's Quaker Oats, which took a billion dollar write-off for its Snapple fiasco.

It is possible to benefit from the process, yet the architects of many a surefire deal too often end up scratching their heads and wondering why they got a dud. After all, they followed the canons of due diligence, thoroughly exploring the financial and legal aspects of the transaction. Trouble is, they overlooked other potential sources of failure. If the focus of due diligence is just legal and financial, other risk factors can fester until implementation begins. By then, you can't do much but cut your losses and look stunned.

Or they may have been caught up in the "romance of the deal." Business acquisitions are hypnotic. You see two companies, their hearts beating as one, dancing to the beat of commerce, lucratively in love. And you fall hard. The due diligence process creates momentum that causes companies to acquire businesses they know in their hearts are likely to fail. But the due diligence team and its M&A advisers put so much time, effort and money into the proposition, it's nearly impossible for them to turn back.

Watch Your Step

The high failure rate is the result of the way managers think. In a process that should be exhaustively thorough, they take shortcuts that create "decision traps" that lead them to ignore, overlook or rationalize key information. Three of the deadliest are the confirmation trap, availability trap and escalation trap. Acquisitions don't fail because of the unknown, but because managers are unwilling to face the known.

Companies caught in the confirmation trap focus on data that confirm or support the transaction and ignore adverse information. Disregarding the seeds of failure won't make them stop growing. You can avoid this trap through deliberate attention to "disconfirming" the information, being realistic when making acquisition decisions and optimistic when implementing them.

Relying on the most conspicuous information gets companies ensnared in the availability trap. Often, acquisition decisions are based on the input of too few people. Critical issues and pitfalls get overlooked. But awareness of how availability can bias the acquisition decision - and systematic examination of less obvious viewpoints - can disarm it.

The escalation trap takes over once due diligence is underway. All the time and effort due diligence requires becomes a factor in the equation. And managers forget one basic principle of any investment decision: Ignore skunk costs! Moreover, turning back implies their original decision to pursue the acquisition was ill-conceived. The odds of stopping the due diligence express once it builds up a head of steam are slim to none.

Now That You Mention It...

Strategic risk analysis is a structured process for overcoming these traps. It applies critical thinking to acquisition decisions. Discouraging the drift toward confirming information, risk analysis uncovers possible flaws and stumbling blocks and corrects emotion-laden biases. Once pitfalls are exposed, the management team can systematically analyze them during due diligence and proactively address them during implementation.

"Most people spend their time looking at acquisitions from the standpoint of how good they are," says Kenneth Donohue, president of CCL Container. "But the strategic approach is, 'Tell me everything bad that could happen, and do we have a plan in case it does?'"

Unfortunately, employees may be reluctant to criticize a new idea, preferring to be helpful and supportive.More often than not, the champion of the acquisition is a senior executive or even the CEO. Under these circumstances, taking a critical look at the CEO's pet project is distasteful at best. A risk-analysis session conducted by an experienced, skilled facilitator can replace emotion and internal bias with focus and objectivity, paving the way for consensus whether the upshot is to stop or move forward.

The process does kill some deals. It should - especially deals driven by emotion rather than logic. But, by providing a clear sense of direction and building team commitment, it also strengthens deals that would otherwise fail during implementation. Only after exploring why an acquisition or merger might not work can companies realistically evaluate chances for success; understanding the risks and addressing them in advance can prevent unpleasant surprises during implementation.

Weighing lite Urge to Merge

A day-long facilitated risk analysis session has three parts: the strategic risk profile, risk/response matrix and feedback and decision-making.

To create a strategic risk profile, the management team, including top executives and their direct reports, meet in a structured brainstorming session to identify and categorize all potential threats to the deal's success. The structured process ensures honest expression of all critical points. Categorizing risk factors around common underlying issues helps comprehension and provides a checklist for the due diligence team.

They formulate a risk/response matrix, applying two questions to the potential risk factors: What's the probability that the problem will cause the venture to fail? And, if the problem were to occur, could the company respond effectively?

Through the team's responses, four types of risk factors - killers, controllables, nuisances and ambushes - emerge. The same template doesn't apply to every acquisition, though, because one company's potential killer (pressure to unionize, say) is another company's nuisance. Identifying these risk factors is a process unique to each situation.

Killers have a high probability of causing failure, while the company has a low response capability. Killer events - like losing your top management team, or finding that a technology or product isn't as far along in development as you anticipated - are the most compelling predictors of failure. They're red lights at dangerous crossings; proceeding without carefully analyzing and addressing them is almost certainly fatal.

Controllables - like integrating accounting systems or realizing your company is becoming distracted by the acquisition and thus is stretching too thin - are likely to occur, but the company could effectively respond. If the acquisition moves ahead, the company must develop action plans to ensure they're addressed during implementation. Worse than ignoring killers would be doing nothing about controllable risk factors.

Nuisances are unlikely events to which the company could respond, if necessary. They require minimal attention and need be addressed only when and if they arise. A typical example is a shortage of staff.

Ambushes are unlikely events that could, nevertheless, kill the venture. These probably are beyond a company's control, such as acts of God or government coups. No merger is 100-percent safe, but managers are usually willing to accept these risk factors.

In the feedback and decision-making process, the session facilitator presents the risk factors, arranged by category and priority, to the management team. Depending on the session's focus, the team generates specific action items for the due diligence squad to investigate. It then makes a go/no-go decision if due diligence has been completed, or develops action items for an integration plan if the deal has taken place.

"I don't think any project of consequence should be undertaken without this type of risk assessment," says Ed Brachocki, vice president of corporate development at Go-Video, an Arizona-based video technology company. Brachocki likens strategic analysis to a corporate encounter session: "It's an opportunity to discover deeper company issues, including how employees view your company's strengths and weaknesses."

Risk Analysis in Action

Many companies have profited from strategic risk analysis as a decision-making tool. It brings key factors to light and thus illuminates the wisest course of action. Here's how the process worked for four companies.

DynCorp, a $1 billion information technology and management services firm in Reston, Va., wanted to expand into managed healthcare, a growing market where it might leverage its IT expertise. But CFO Patrick FitzPatrick was concerned about its limited healthcare experience. If DynCorp's strategy were to succeed, the first few healthcare acquisitions had to provide a sound foundation on which to build the expanding business.

The due-diligence team, corporate staff and a healthcare expert used strategic risk analysis to develop a targeted, prioritized due-diligence checklist. "The session helped identify and highlight areas that might otherwise have been taken for granted," FitzPatrick says. "It brought into focus 13 high-risk issues - potential deal killers the due-diligence team needed to thoroughly investigate." These included questions as to who owned the rights to software DynCorp was acquiring, major changes in healthcare delivery and concerns about achieving margins and return on investment capital.

Satisfied there were no real deal killers, DynCorp moved ahead confidently with the acquisition. The business is being integrated into its operations and is meeting management's expectations.

Woodward Governor of Rockford, Ill. has an illustrious 125-year history manufacturing industrial and aircraft control systems. But initial acquisitions starting in 1991 hadn't met company objectives. It needed a more defined process, one that would go beyond the financial issues and lead to an honest assessment of the deal.

Before pursuing its next acquisition, Woodward completed a risk-analysis session. The due-diligence team and representatives of HR, R&D, IS, accounting and marketing identified and prioritized over 60 possible risk factors that could cause the venture to fail. According to CFO Steve Carter, "The process brought into focus the bigger picture - a broader set of issues - and helped solidify the team. Getting so many people together to think about the issues and getting them focused was very positive."

Using the risk analysis, Woodward's due diligence team was armed with a checklist for the engineering unit and specific questions about compliance capabilities and quality certifications. It also looked at the target's ability to produce products outside its industry, because it saw potential there, but found certain technologies were not transferable, and was further concerned about quality control. Woodward was able to complete its due diligence quickly, and recently signed a purchase agreement to acquire the business.

"Our due diligence team moved faster and more concisely because of the thinking we did that day," says Gary Larrew, vice president of business development. "I don't think we could have achieved that type of teamwork any other way. My confidence in our due diligence is much higher than in the past. I can sleep at night knowing we haven't overlooked anything."

All Aboard

Axxess Technologies in Tempe, Ariz., specialized in supplying key duplication equipment to high-volume, mass-market merchandisers. Now the company was considering an acquisition. The target handled manual equipment that was older and harder to operate, but the venture would enable Axxess to enter new markets.

Two circumstances were particularly troubling. Because Axxess and the target were direct competitors, reliable information was scarce. Moreover, the target was a union shop twice Axxess' size, and Axxess was afraid its acquisition might lead to a unionization of the whole company. So, all members of management met in a strategic risk session to "kick the tires" and air concerns before finalizing the deal; participants left satisfied that they'd examined the key issues and addressed all potential challenges. Axxess president Steve Miller says, "The process was a great way to close the loop and present issues, and to find reasonable ways to get around hurdles that might arise."

The group recommended moving forward with the acquisition, and Axxess is now integrating the two operations. "The process brought us together as a unit and got everyone behind the effort," Miller adds.

MicroAge, a $4 billion, Tempe, Ariz.-based hardware/software distributor, was contemplating a $20 million takeover. But a string of failed acquisitions previously cost millions in write-offs; MicroAge could afford no more mistakes. Due diligence reports were favorable and upper management was negotiating an offer but managers disagreed about the acquisition's merits. So the company used strategic risk analysis to achieve consensus for the decision.

The process challenged management to identify and evaluate key assumptions about this opportunity. Midlevel management, formerly absent from acquisition deliberations, raised new issues, and the group exposed a host of critical concerns - including the fact that the acquisition wouldn't meet MicroAge's strategic needs, wouldn't get them into the market they wanted to be in and might actually cannibalize its core sales. So, with the team's agreement, CFO Jim Daniel decided to walk away from the pending $20 million deal. As senior vice president Warren Mills puts it, "It wasn't the decision I wanted, but it was the best decision for the company."

Preventive Medicine 

As companies struggle for competitive advantage, an ill-conceived merger or acquisition damages not only profitability but the health of the core business as well. Failed growth strategies deplete company resources: personnel, finances, morale and more. Strategic risk analysis isn't about killing deals; it's about making sure you're getting the right deal and inoculating deals that can succeed against possible failure.

It's all about making the numbers add up to success.

Richard Z. Gooding, Ph.D., is founder and president of Strategic Advantage, Inc. (www.strategy4u.com), in Phoenix, Ariz. He can be reached at [phone].