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Mergers & Acquisitions Issues: Customer Concentration

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Concentration as it relates to selling an established business means that a large percentage of sales, purchases, or some other critical business metrics are concentrated in one or two big customers, industries, products, vendors, or employees.

In founder led businesses the most common situation is customer concentration. Business owners frequently look at this as a good thing, since having one or two major customers that provide sufficient business to run the company profitably can be done efficiently. There is no need for outside sales – the purchase orders just keep coming in. There is minimal staffing required for customer service since most of the jobs are repeat orders. The business owner understands the critical issues that are most important to their key customers and manages those factors tightly. This is relatively easy since there are only one or two customers to manage.

Often, the business owner has a personal relationship with key people among these customers, such as the CEO, CFO, Purchasing Manager, Engineering Manager, etc. The business owner feels very confident that the relationship will endure for the foreseeable future and is very comfortable with the customer concentration.

In summary, business owners often feel that customer concentration is a good thing that benefits the business with long-term relationships, smaller staffing requirements, and few technical issues since most orders are repeats.

Business buyers have a different perspective: risk. If one customer provides 50% of revenues year after year, the loss of that customer once the seller is gone would cause major harm to the business. It may still be marginally profitable with the loss of 50% of revenues, but there may not be enough cash flow to pay principal and interest on acquisition debt. Further, the buyer will object that he did not get what he paid for in the purchase of the business and sue the seller. The buyer, as the new owner, may lay off workers causing them distress and financial pain. He may or may not be able to hire those workers when business picks up, making it difficult to get production back to its former levels. In the worst-case scenario, the loss of the 50% customer may cause the business to fail and be liquidated.

If the buyer is a private equity firm, the buyer is investing funds provided by its investors: insurance companies, corporations, high net worth individuals, retirement funds, and other institutions. The private equity firm and the individuals who own it are accountable to their investors for the preservation of their invested equity as well as the expected return on investment. If they buy a company that has a customer representing 50% of revenues, then lose that customer and the company fails, it is disastrous for the investors and for the private equity fund managers as well. They may lose their ability to work in the private equity industry and suffer great personal financial loss.

From the perspective of most buyers, companies with high levels of customer concentration are too risky to buy. If there is something about the subject company that is highly desirable, such as a key customer that the buyer really wants, some proprietary technology, or some other feature, the buyer may offer to acquire the business, but the terms will be structured to put risk on the seller.

How do buyers structure transactions to put the risk of losing the key customers on the seller? The most common method is a contingent variable payment, commonly called an earnout.   The earnout payments will depend on continued revenues from the key customers. If those revenues do not happen, then the payment will be reduced or even eliminated entirely. This results in the total purchase price being far less than the potential purchase price that would be realized if the sales from the key customers met the benchmark metric specified in the purchase agreement.

A second common way for the buyer to manage risk is to pay a lower price that considers the risk of losing key customers. For example, if comparable sales indicate that businesses similar to the subject business sell in the range of 3 to 4 times earnings, then a buyer may only be willing to pay 2 times earnings because of the possible loss of the key customers.

What can a business owner do to avoid getting into this sale situation to prepare the business? The obvious answer is to diversify the customer base. The ideal situation is to have no customer that represents more than 10% of total revenues, and to have no more than one-third of revenues from one industry. It is best if customers’ industries have complementary cyclicality – in other words, when one industry is down the others are up, yielding a steady revenue stream for the business. This process can take two to three years, since the new customer relationships need to be seasoned enough that the buyer of the business is confident that the relationships will continue. Also, the increased revenue and earnings should show in at least one year-end P&L and tax return to have merit in valuing the business.

If you are a business owner and you are thinking about selling your business in a few years, please contact us for an evaluation of your business and collaboration in creating a plan to reach the business valuation goal that will enable you to go on to whatever is next.