Article US Business Review

Eyes Wide Open

Entrepreneur David Krumrine turned a passion for baking, learned from his grandmother, into a successful company. It grew to include five bakeries producing private-label cookies and crackers. Krumrine was a sleeves-rolled-up CEO, who loathed sitting behind a desk. His keen taste ensured a broadening customer base and steadily increasing sales volume. His success eventually attracted the attention of a national bakery group seeking to add a private label.

The bakery group made an attractive cash offer. Negotiations were brief. Krumrine's only major condition was that he be allowed to continue to play a role in guiding the company he'd founded. Bakery group executives barely hesitated, happy to make use of Krumrine's cookie expertise. They agreed he would remain as vice president/executive pastry chef overseeing the private label. The deal was celebrated with champagne and a sampler tray of specialty cookies and crackers.

The honeymoon lasted three months. Krumrine (a pseudonym) had developed his own seat-of-the-pants management style during two decades of successful operation, and saw little reason to change, despite how his new bosses thought a corporate vice president should operate. If he had a cookie inspiration, Krumrine would spend hours in the kitchen, ignoring everything else on his schedule. Meetings were missed and reports ignored. There were long, unexplained absences from the office.
In part, this was Krumrine's style. But also - unbeknownst to bakery group executives - Krumrine had recently plunged into a raging mid-life crisis. Just days after completing the sale of his company, he'd left his wife of 25 years and taken up with an exotic dancer he'd met on one of those long, unexplained absences - a gambling foray to Atlantic City.
The new owners' patience eventually wore thin. Krumrine was called in for a meeting, told frankly what was expected of him and presented with a detailed job description. Indignant, he stormed out. Within a week, the termination letter was delivered. Krumrine retained a lawyer and sued. Legal fees and the eventual settlement cost the bakery group seven figures, but the disruption to operations at a critical time was just as costly.
It all might have been avoided.
The Entrepreneurial Personality
As the economy recovers, another upsurge in the merger and acquisition cycle is likely. But if private equity funds, venture capitalists and others are to avoid the mistakes that plagued many deals during the last boom in the cycle - and which propelled a surprising number of them into litigation or arbitration - they need to take to heart the lesson exemplified by the bakery group's experience.
That lesson is quite simple: Dealmaking is more than just numbers. To be successful, dealmakers should also take into account the human factor, lest they are caught up in the problems that often lead to litigation or arbitration.
At the heart of any deal is the person who made the target company an attractive prospect for acquisition: The entrepreneur. Because the entrepreneur has been so intimately involved with the company's success, it often seems to make a great deal of sense to keep him or her - along with his or her contacts and ideas - involved in the new company. But the venture capitalist should pause to consider what makes a successful entrepreneur.
An entrepreneur who has started and nurtured a growing small to mid-cap business that is most attractive to private equity is almost always self-motivated, confident and sure of his own business judgment. He believes his instincts are the correct ones. Like "David Krumrine," he may have a management style that goes against the grain of a more-structured corporate bureaucracy. In addition, the entrepreneur almost certainly feels highly protective of the company he founded, and great loyalty to employees. These traits can be attractive in the right context, but they can work against the interests of the new owners. The entrepreneur's loyalty to employees, for instance, could lead him to balk at the new owners' efforts to maximize their investment with cost-cutting measures.
Some giant companies that have grown extensively through acquisitions - Cisco Systems is a good example - have procedures in place to address these human factors in the merger process. But such foresight is rare, and if the due diligence investigates only the financial and legal background of the target company, it hasn't gone far enough. 
The private equity specialist needs to develop a broader view of dealmaking, and the first step is to ask a fundamental question: How important to the future success of the company is the entrepreneur's continued involvement? Her knowledge of research, development, production and marketing may be extensive. Her relationship with key customers may be valuable. In addition, there may be key employees who will remain with the company only as long as the entrepreneur does. After weighing these factors, the venture capitalist may want the entrepreneur's continued involvement. 
It's at this point - well before serious negotiating ends - that the venture capitalist needs to have a clear and rational view of just who the entrepreneur is. How does she manage her own activities and those of the people who work for her? What type of bureaucracy, if any, has the entrepreneur created for the company? What sort of corporate culture has she fostered? How does she respond to authority and how well does she take direction? What experience has she had in working for others? Is she solid and dependable?
Questions like these go to the heart of the entrepreneur's personality. Answering them in a truly informed way requires training and skills that few private equity entrepreneurs, no matter how acute their intuition, possess. For this reason, venture capitalists should consider requiring a potential acquisition target to undergo a specialized personality and psychological assessment. This assessment can provide the necessary information to develop a clear and rational view of the entrepreneur.
This trend toward a more formalized assessment has not yet turned up in private equity or venture capital circles, and most deals go forward without the idea even being mentioned. But the day may be coming when, like Cisco and the other big merger and acquisition players, the private equity and venture capital due diligence teams expand to include an organizational or business psychologist. Such a professional can be extremely useful - indeed, critical in some situations - and can add significant value to some deals, particularly where personality and culture clash show early signs of presenting an obstacle.
Business Psychologists
These specialized management consultants have been used in other corporate settings to lead the way in succession planning, hiring and leadership and executive development. They also can create a useful personality portrait of the entrepreneur. To do this, a psychologist-consultant will give the entrepreneur standardized personality tests and conduct in-depth interviews to learn about family and educational background, work history, habits, interests, values and goals. The consultant will also survey the entrepreneur's work environment to create a more complete "data mirror" to reveal management style, motivations and areas of potential trouble.
Such a process - lasting a few weeks - will fit right into the current due diligence timeline with minimal burden on the overall deal. This process also can save the venture capitalist the expense of litigation and loss of productivity that could result from making an uninformed choice. With the consultant's assessment in hand and the due diligence on the entrepreneur complete, the newly expert private equity lender now has to decide how to proceed.
The entrepreneur may have made it clear that he doesn't want to be cashed out and simply walk away. But at the same time, the consultant's assessment may indicate that the entrepreneur's personality and management style won't mesh well with the values of the new company. It may be possible to convince the entrepreneur that he just wouldn't be a good fit; the business psychologist can play a role here, working with the entrepreneur to help him reach the appropriate conclusion.
But if the entrepreneur continues to insist on an ongoing role in the company, the venture capitalist has a choice to make: Proceed, but with a very clear understanding of the risks involved. Or, walk away from the deal entirely.
If the decision is made to proceed, some additional steps should be taken to make the risk more manageable.
Precision the Documents
Even in the preparation of a deal's legal armor, the human factor has to be kept in mind. Among the transactional documents, there should be a carefully prepared employment agreement. How this document is worded depends upon the role foreseen for the entrepreneur. If he is seen as a high-risk individual whose role is not critical, then his duties with the new company should be couched in general terms - something like "strategic planning" would be a good choice.
The same vagueness should carry over into his job title. "Vice chairman," for example, is general enough that, should the relationship break down and the dispute end up in court or arbitration, the entrepreneur can't argue that his title implied any specific executive authority.
To provide further protection, the employment agreement should contain a powerful integration clause specifically and explicitly limiting the entrepreneur's expectations to the written job description. In this way, there can be no future claims by the entrepreneur that he was relying on any sort of verbal guarantee or agreement.
But what if - because of knowledge or customer contacts - the entrepreneur has a very real and valuable part to play in the new company? No matter how critical this may seem, the venture capitalist still needs to protect himself. In this case, the employment agreement should be more detailed. It should state in no uncertain terms that the company is relying on the entrepreneur to devote full time, energy and skill to the work and that maintaining the relationship depends on fulfilling certain responsibilities. The job description should be specific about those responsibilities. The entrepreneur should be required to spend a certain number of hours a week in the office and to maintain a specified schedule of meetings with top executives, managers, supervisors and subordinates. If the entrepreneur is involved in making customer contacts, then the agreement should spell out how much time he is expected to spend on the road. 
The employment agreement should also address compensation in detail, tying it directly to performing specific duties and meeting definite goals such as sales targets or profitability levels. This protects the private equity lender and also provides an incentive for the entrepreneur to do good work. The agreement should also address another issue, which, if ignored, could become explosive. Over the years the entrepreneur may have grown accustomed to treating the company's finances as if they were personal, thinking nothing of taking money from a company account to pay for, say, a trip that has nothing to do with business. This is probably not a practice the new owner approves of. This should be explicitly stated in the employment agreement. 
Finally, the employment agreement should contain non-competition and confidentiality clauses and should require that all computer files be kept on the company's server and accessed through a network. And, in case the worst does happen, the employment agreement should contain an arbitration clause. Make it detailed and specific, setting out where the arbitration should take place and which state's law would be applicable. And, of course, it should be stated that the prevailing party will be reimbursed for the fees and costs of the arbitration.
This step-by-step process may seem to be filled with red flags. Perhaps it is. But it's worth remembering that acquisition is one of the fundamental ways in which business, and the economy in general, expands. Because of its critical importance, it should be entered into only with eyes wide open and with an understanding of all the factors that can make it a success - or litter the road ahead with potholes. 
Rick Richmond is a senior partner with Kirkland & Ellis' Los Angeles office. He can be reached at 213-680-8452, or at The views expressed here are solely his own and do not necessarily represent the views of Kirkland & Ellis or any of its practice groups or individual attorneys. The "David Krumrine" example is a composite developed from several situations faced by Richmond's clients.
Alan Hack, a psychologist, leads MMC, a management consulting firm that deals with the psychological and organizational challenges involving personnel and business. He can be reached at 212-307-9730, or at
Reprinted with permission from US Business Review, November 2002