I was helping conduct due diligence on a private company that was potentially being acquired by my friend’s much larger and more industry-established public company. The acquisition would surely increase the established company’s presence in the industry and would be a major coup for the CEO of the pubco.
Besides my friend, I knew some of the players in the other company being acquired. My friend was putting several million dollars at stake with this deal. I had a gnawing ache in the back of my neck that made me feel there was an issue that I couldn’t put my finger on. I knew I had to look deeper. I felt it was an issue with management that gave me an uneasy feeling but wasn’t sure.
There are many steps to a due diligence analysis but I felt the place to start was with the team and those involved in the early seed rounds of the startup. I put the usual steps at the end; the business model, market opportunities, customers, industry and the competition. I think the management team is one of the most critical aspects of the business so I figured I’d focus on them first.
I did a CV and resume check then looked through a LinkedIn review of each senior executive. They all appeared fine even after background checks. I went through the founding team to see if there were any unsettling issues or management conflicts that could be chinks in the armor. The founders were college buds that had the same vision and were dedicated to the company. They reminded me of the Winklevoss twins of Facebook fame with a good attitude and a naïve belief that everything was the way it should be.
These young guys had surrounded themselves with a great team of experienced advisors and the Board of Directors was seasoned professionals. The team appeared to be young but somewhat experienced without track records, as such, but that was not expected by guys in their twenties. They were certainly aligned with the vision of the company and there was a great camaraderie within the team. Their skill sets were also complementary. Maybe my instinct was a top down problem so I looked at the CEO.
The CEO was a team player who demonstrated leadership throughout the startup process, pivoted when needed and on the surface picked the right individuals to manage the different aspects of the company. He was the perfect pitchman, well connected and networked everywhere. You could tell he was the CEO who looked good, handled conflict well and was loved by his investors. He had a good story and people loved it.
I looked at any shareholder issues. They were all compliant, none were disruptive or out for an alternative rationale for investing. None appeared to be sharks or out to take over the company or VC’s with strings attached. The last two rounds had been accomplished successfully and had passed scrutiny.
I took a step back and looked at the corporate assets. The IP’s and patents were in place and secure. The technology-based company had a great infrastructure in place and employees took great pride in the operation.
The stakeholders, mainly the employees, were excited about being part of a bigger picture and many looked forward to cashing in on a possible pubco merger and it’s following bonanza for their hard work.
I was starting to think that my spider sense was simply a pinched nerve in the back of my neck and I should tell my CEO bud to close the deal as all was in ‘good order.’
Over a drink with my bud he mentioned that there seemed to be trading irregularities with his pubco stock over the past few days and he was concerned. They weren’t outstandingly huge amounts just large enough to disrupt the usual pattern. He suspected it was insider trading. What tends to trigger the suspicion of insider trading is huge amounts of stock either being sold off or bought before a big event. This merger would be considered a big event. Yikes!
According to Investopedia “the more infamous form of insider trading is the illegal use of non-public material information for profit. It’s important to remember this can be done by anyone, including company executives, their friends and relatives, or just a regular person on the street, as long as the information is not publicly known.”
There are a variety of statistical tools that detect uncharacteristic trading. It’s easier to detect insider trades when they happen very close to important news events.
Ok, time to get serious. I can’t say I am a brilliant investigator, although as a Federal Parole Officer in an early career I always trusted my hunches. I decided to take another look at the senior managers who were aware of the impending merger. It’s funny when you avoid the traditional avenues and look to other sources like executives’ drinking buddies and such.
With lots of innuendo but without solid evidence I felt that the brother-in-law of the CTO/Director of the ‘to be merged’ company was the inside trader. Loose lips sink ships!
When confronted, the CTO admitted he might have ‘spoken out of turn’ about the merger but didn’t think it was a big deal. It could be the beginning of a very big deal if something wasn’t done.
My CEO friend was decisive and immediately halted all negotiations for the acquisition of the private company. Some of the obligations of the Director of a company is to act in good faith in the best interests of the company, act with care and diligence and is prohibited against the misuse of information obtained as a director. The CTO had failed in all of his obligations.
Insider trading or aspects of it including insider information probably happens all the time but my friend was grateful that he ‘dodged a bullet’. It’s not worth a penny of unearned money to put a corporation at risk.
Due diligence must be extensive and gut feelings must be followed. In this scenario, the private company continued on without their founding CTO but found success many years later – loose lips sink ships!