Few owners recognize the great impact that customer concentration has on the sale of their business. Customer concentration represents a major hurdle and will affect the sales ability, valuation and deal structure of a business transaction. Not only will it create problems qualifying buyers, but it will affect any potential buyer’s ability 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 business 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 any situation, a great risk is created by the lack of diversification and measures to mitigate it must be taken years before a planned business exit.
When evaluating the sale of a business, it is important for the owner to recognize that their customer base has a significant impact on the business value of the business. A broad and diverse customer base where there are a large number of customers contributing to the business revenue will achieve a higher transaction value by reducing the risk of a significant decrease in profit occurring if a customer or a company is lost. industry in particular. segment served by the company is facing economic difficulties.
In addition to a lower selling price, companies with customer concentration problems are more difficult to market for sale. For major business transactions (those with adjusted earnings of less than $ 2 billion), 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 decline the loan entirely. In situations where third-party financing is not available, the pool of available buyers is significantly restricted and the terms of a deal could weigh heavily in a contingent gain based on the retention of revenue derived from major clients. “Generally, we don’t want a client concentration of more than 10% when we consider financing an acquisition. Higher standards are possible with much more explanation and supporting documentation, but it is still a major concern,” says Steve Mariani, President of Diamond Financial Services.
Finally, customer concentration will have a direct impact on the deal structure for the commercial sales transaction. Buyers will strive to overcome the risk of customer concentration through a variety of lagged “performance-based” 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 that proceeds are sustained after the sale. After a 12-month period, if the customer and the proceeds are still in place, the seller will receive the funds. If the identified customer and the corresponding revenue were lost during this period, a price adjustment would be made.
In situations where the buyer is unable to obtain financing for the transaction due to customer concentration issues, the seller may have to accept a “contingent profit” on the income derived from the largest customers or, worse, also you may have to finance a portion of the “non-contingent purchase price” negotiated with buyers.
Contingent payments can be structured in a variety of methods:
Dedicate part of the purchase price to payments made over a period of time that depends on the retention of specific customers or the achievement of specific revenue goals.
A percentage of the purchase price will be held in an escrow account for a specified time.
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 income derived from the largest 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 a more active participation in the maintenance of the relationship with the client during the period of validity. the agreement. Obviously, this adds 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 receive assurances that the risk is low. While the obvious strategy for reducing customer concentration risk is to diversify and grow the commercial customer base, there are a number of situations where customer concentration does not pose significant risk or could be mitigated.
Having a current contract will not eliminate all risk of losing a key customer, but it will give the buyer the assurance that income and profits will continue after a change in 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 without 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 industry or government contracting) that create a barrier to entry for potential competitors.
Provide a variety of products and / or services:
Having an extensive relationship with a key customer where the relationship is not based solely on a product, a location and an individual decreases the risk that a singular change will fundamentally impact the future income stream and the continuity of the account.
Economies of scale or synergies:
The acquisition can be made by a strategic buyer when it is bringing new products / services to the company, a wider geographic footprint or economies of scale in production. Any of these elements would help reduce the concentration of revenue risk that an identified key customer would pose to the future organization.
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 acquirer. Ultimately, the buyer only seeks to retain customers who have contributed to the success of the business and who are factored into the valuation and transaction price. From a buyer’s position, some logical questions and concerns would be:
How does the value of the business change if a customer representing 10% or more of revenue and / or profits is lost in the first year?
How easy would it be for the customer who represents the customer concentration concern to leave the business?
What unique situations exist within the business to preserve the customer relationship for years to come?
What are the logical steps and corresponding costs to mitigate customer concentration risk?
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 remuneration 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 focus is more acceptable and a proper explanation should be provided to the buyer as soon as possible. Meeting this potential challenge is critical to achieving a win-win deal. When there is good communication and there are two fair and reasonable parties at the table, there are a number of structuring options available, where necessary, to mitigate risk and negotiate a fair and reasonable transaction price. Obviously, the best approach for a potential business salesperson would be to develop and implement plans to reduce any element of customer concentration years before 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.