Few owners recognize the huge impact customer concentration has on the sale of their business. Customer concentration represents a significant obstacle and will affect the saleability, valuation and negotiation structure of a business transaction for sale. Not only will it create buyer qualification issues, but it will affect the ability of any prospective buyer to obtain third-party financing to complete the acquisition. Determining whether customer concentration is present in a company is a critical element of the succession planning process.
Customer concentration is a situation where one customer represents a significant portion of revenue or when the company has a very small customer base. Depending on the expert consulted, the exact percentage for a concentration to exist varies. In most cases, it is recognized when a customer represents more than 10% of sales or when the top five customers comprise more than 25% of a company’s revenue. In either situation, great risk is created by a lack of diversification and steps must be taken to mitigate it years in advance of a planned trade exit.
When evaluating a business for sale, it is important for an owner to recognize that their customer base has a significant impact on the business value of the business. A large and diverse customer base where there are a large number of customers contributing to business revenue will achieve a higher transaction value, as it reduces the risk of a significant decline in profits if a customer or a business is lost. particular industry. The segment that the company serves is experiencing financial difficulties.
In addition to a lower sales price, businesses with customer concentration issues are more difficult to market for sale. For high street trading transactions (those with adjusted earnings of less than $2mm) third party financing is used in most cases. Companies with high levels of customer concentration are very difficult to finance. Lenders may provide only partial financing, offer suboptimal terms, or reject the loan entirely. In situations where third-party financing is not available, the pool of available buyers is significantly restricted and the terms of an agreement could be heavily weighted on a contingent profit based on retaining revenue earned by the largest clients. “Typically, we don’t want customer concentration above 10% when considering financing an acquisition. Higher levels are possible with much more explanation and supporting documentation, but it remains a major concern,” says Steve Mariani, president of Diamond Financial Services.
Finally, the concentration of customers will have a direct impact on the structure of agreements for the transaction of sale of businesses. Buyers will strive to overcome customer concentration risk through a variety of ‘performance-based’ deferred financing methods. For example: Suppose both parties agree to a transaction price of $900,000 based on $300,000 of adjusted earnings (a multiple of 3x). If the key account in question represents $75,000 of the $300,000, this would represent $225,000 of the transaction price. A buyer will endeavor to isolate the $225,000 component to ensure proceeds are sustained after the sale. After a 12-month period, if the customer and income are still current, the seller would receive the funds. If the identified customer and corresponding revenue were lost during this period, a price adjustment would be made.
In situations where the buyer is unable to obtain transaction financing due to customer concentration issues, the seller may have to accept a “contingent gain” on revenue from major customers or, worse, also may have to finance a significant portion of the “non-contingent purchase price” negotiated with buyers.
Contingent payments can be structured in a variety of methods:
Consume:
Allocate part of the purchase price to payments made over a period of time conditioned on the retention of specific customers or the achievement of specific revenue goals.
Deposit:
A percentage of the purchase price will be held in an escrow account for a specified time.
Seller-Financing:
The seller would be responsible for financing a significant portion of the purchase price through a seller’s note. The seller’s note could be structured with contingencies for revenue from larger customers.
With any of these deal structuring techniques, the seller cannot be expected to guarantee income in perpetuity and if the transaction price is based on the retention of one or more key customers, the seller may require more active participation in maintaining the relationship with the client during the term of the agreement. Obviously, this brings additional complexity to the transaction.
In most cases, buyers will seek to discount the amount they are willing to pay for a business (with a high concentration of customers) unless they are reassured that the risk is low. While the obvious strategy to reduce customer concentration risk is to diversify and grow your business customer base, there are a number of situations where customer concentration does not represent a significant risk or could be mitigated.
Customer contracts:
Having a current contract will not eliminate all risk of losing a key customer, but it will provide the buyer with the assurance that income and profits will continue after a change of ownership occurs. When it comes to customer contracts, it will be important to understand the ability to assign or transfer. In many cases, a stock sale vs. the sale of assets is chosen to preserve these contracts.
Entry or Exit Barriers:
Companies may have intellectual property, product expertise, or patents that create competitive advantages that prevent competition. Others are located in geographically remote areas where the benefits of supply discourage customers from changing the relationship. Finally, there could be significant capital requirements for manufacturing and tooling or agency approvals (pharmaceutical or government contracting industry) that create a barrier to entry for potential competitors.
Provide a variety of products and/or services:
Having a broad relationship with a key customer where the relationship is not based solely on one product, one location, and one person decreases the risk that a singular change will fundamentally affect future revenue streams and account continuity.
Economies of Scale or Synergies:
The acquisition can be carried out by a strategic buyer that brings new products/services to the company, a wider geographic distribution or economies of scale in production. Any of these elements would help reduce the concentration of revenue risk that an identified key customer would represent to the future organization.
Summary
Businesses that have high levels of customer concentration are inherently risky, and it is important for the owner to appreciate this concern from the perspective of a potential buyer. Ultimately, the buyer only seeks to retain customers who have contributed to the success of the business and are factored into the valuation and price of the transaction. From a buyer’s position, some logical questions and concerns would be:
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How does the value of the company change if a customer that represents 10% or more of the income and/or profits is lost in the first year?
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How easy would it be for the customer representing the customer concentration concern to go out of business?
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What unique situations exist within the business to preserve the customer relationship for years to come?
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What are the logical steps and corresponding costs to mitigate customer concentration risk?
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How do I achieve a win-win transaction? Protect me, the buyer, against the risk of a short-term loss of income while providing the seller with adequate compensation for the fair market value of their business?
While the risk may not be able to be completely eliminated, there are a number of situations where customer concentration is more acceptable and a proper explanation should be provided to the buyer as soon as possible. Addressing this potential challenge is critical to achieving a win-win agreement. When there is good communication and there are two fair and reasonable parties at the table, a number of structuring options are available, where necessary, to mitigate risk and negotiate a fair and reasonable transaction price. Obviously, the best approach for a potential commercial vendor would be to develop and implement plans to reduce any customer concentration elements years in advance of going out of business. Eliminating this type of risk is just good advice for any small business owner, regardless of whether a sale is being contemplated.