Business owners are usually unaware how two key issues can negatively impact the market value of their business. These are customer and supplier concentration.
Frequently Generational Equity, part of the Generational Group (Generational.com), work with clients who are justifiably proud of the long-term relationship they have developed with an important client. They rightly point out that the only reason that 50% of their revenue comes from this blue chip, Fortune 500 firm is because of the great service and reliable products they provide.
On the surface this is correct. There is no way a Fortune 500 client is going to establish and maintain a relationship with a key supplier if the product and service are not exemplary; multiple alternative sources abound in the market.
However, from a buyer’s viewpoint, even though this relationship may be annually renewed by written contract, there is substantial risk involved. Keep in mind that a buyer will often skeptically assume that one reason the relationship exists is due to the fact that the company’s owner has a personal relationship with a buyer working for the blue chip company, and that this relationship could disappear if the current owner departs.
How this affects value is debatable. Some dealmakers will tell you that the discount rate (the rate applied to future earnings using the Discounted Cash Flow valuation model) will be significantly higher to adjust for this perceived risk. How high this discount rate goes will be driven by a variety of other factors beyond simply customer concentration; however, buyers regularly tell us that after the issue of inaccurate financials, customer concentration is a key risk factor they are concerned about.
We point this out to our readers so that they can be aware of this issue in advance of presenting their companies to buyers.
Some Examples of This in Action
Let’s assume that you are a buyer and have two equally attractive, growing businesses you are reviewing as acquisition opportunities. One has been growing at a compound annual rate of 10% over the past five years (with annual revenue around $5 million) and, likewise, its profit margins have been steadily improving.
The second company has been growing at a 15% clip and is much larger, generating $15 million with steady margins as well. However, the second company has a customer generating 35% of its annual revenue and accounts for even more of its profits, and has been doing so for years.
Assuming that the owners of both businesses are close to retirement and want to exit, the professional buyer will typically assign a greater risk factor (discount rate) to the second company, even though it is larger and has been growing faster. Now you may say, “But wait, isn’t there intrinsic value to the long-term relationship with the customer generating 35% of revenue? Shouldn’t that likewise be factored into the equation?”
The answer to that question is yes and no. Certainly the profits generated over the past five years will be a key positive when being evaluated. However, the seller’s job (and that of his/her M&A advisor if he/she has hired one) is to convince the buyer that this concentration concern is not an issue and the relationship is based on what the business does, not on the owner’s personal interactions.
This can be a tough item to “sell” to a buyer who might simply say, “OK, sounds good but I am going to acquire the first company because even though it is smaller, generating less revenue/profits, the risks associated with its future are lower.” And, in fact, the upside is greater since obviously there is growth potential in this industry.
The Solution to the Dilemma
The real answer to this predicament is to never allow yourself and your business development people to become complacent with their customer base composition. In fact, when we delve into this with most of our clients facing a customer concentration issue we find the same problem time and time again: Lots of potential customers are out there, but the owner has simply lost his/her drive the last few years and has basked in the benefits of having a repeat customer without realizing the downside impact this could have on the market value of the business.
If you are planning to exit in the next few years, it is vital that you review your customer list with your business development staff and determine if the organization as a whole has become far too complacent in seeking new business.
Having said that, it is clear that in some industries, customer concentration is standard. For example, if you are producing jet aircraft engine parts, odds are good that the list of customers you can approach is relatively limited. And if you are approaching buyers who are already in this industry and are aware of this situation being customary, then the risk associated with your opportunity will not be as critical.
However, in most industries this is not the case and lots of potential customers exist.
The same can also be said of supplier concentration. The world quickly learned about vendor issues when the tsunami hit Japan in March of 2011. U.S.-based companies found out the hard way how risky it is to have a limited number of suppliers located in the same geographic area.
The bottom line is this: To enhance your market value in the eyes of potential buyers, never become content with your customer list and supplier sources. Keep pushing your sales, marketing, and operations staffs to diversify, diversify, diversify! In so doing, you will not only help your company grow the right way, you will enhance both your market value and sale-ability.
Carl Doerksen is the Director of Corporate Development at Generational Equity.
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