- The Negative Effect of Concentrations on the Value of a Business - August 17, 2022
- Understanding Business Valuations - June 5, 2019
- What is the Value of My Business and How to Improve It? - May 9, 2019
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When all other factors are equal, the presence of a significant concentration among customers, suppliers, and/or employees results in a lower business value than might otherwise be expected due to the underlying inherent risks associated with any or all of these concentrations.
And for this reason, a business appraiser will use a higher required return (or discount rate), a lower forecast of future earnings, a lower expected earnings growth rate, and/or a lower capitalization factor (earnings or cash flow multiple) in order to form his or her opinion of value.
If the business is on the market, buyers will also view concentrations as an elevated risk and either pay you less for the business or dismiss the opportunity altogether.
There are several concentrations that business owners should be aware of that have a negative affect on the value of their business. These concentrations include:
- Customer Concentration
- Supplier Concentration
- Employee Concentration
How Customer Concentration Affects Business Value?
Many small businesses have a handful of customers who generate a large percentage of their revenue. Buyers will usually review any client relationship that accounts for more than 10% of revenue and consider it as a customer concentration. Losing one of these key customers could stifle a business’ revenue and derail its ability to generate a profit.
Due to this risk, buyers will generally apply a valuation discount to companies with a high degree of customer concentration. Many buyers are wary of companies that derive a majority of their revenue from a few customers. Although some strategic buyers may be attracted to a company if it has a strong relationship with a particular client, this is an exception rather than the norm.
A concentrated customer base increases the risk for the owner and for potential purchasers. For a potential purchaser to invest in a business with a customer concentration, their rate of return will need to be higher, which translates into a lower purchase price.
Additionally, business owners must be aware that a high client concentration is problematic for potential buyers who plan to borrow money to finance the acquisition because bankers and other lenders will consider a high customer concentration to be an elevated risk . They will consider the buyer’s capacity to maintain the same level of revenue and profit in order to service debt. If the buyer cannot justify the risk, diversify away from the risk, or add new clients, the lender may believe there is too much risk. .
A lender may reject the loan application or may be likely only to offer a partial loan to the buyer if there are customer concentration concerns. The less money borrowed, the less money the seller will get up front when the deal closes.
From an evaluation perspective, many potential business purchasers would view a single client representing 10% to 15% of revenues as a significant negative. Nearly all potential buyers would view client concentration of 30% or more in only two to three clients as a serious issue that would significantly affect the business’ salability.
Any efforts you make to diversify your clientele before selling your company will improve its salability, valuation, and ability to generate the most money at closing.
Most prospective purchasers may attempt to set up a “contingent earn-out” paid to the seller over time which is dependent on the future revenue or profitability received from the company’s largest customers in order to alleviate customer concentration issues. If one of those customers is lost, the seller may never receive the contingent portion of the negotiated purchase price.
How Supplier Concentration Affects Business Value
If a business can’t get what it needs from suppliers, it can’t sell its products to customers. A company’s business may suffer if its connections with its major suppliers deteriorate or if one of its core products or components is no longer available to buy for resale or for production purposes. Therefore, when determining a company’s risk, the character and stability of its suppliers is a crucial factor.
Small business owners often find a reliable supplier to rely on for the majority of their product or material requirements. Why not make your life easy and continue working with a dependable person or organization when you find one?
While the strategy of working with only one or a few trusted suppliers makes running a business less complicated, it can prove to be risky. The Covid pandemic created supply chain issues worldwide. Not even the smallest businesses escaped its negative effects.
For larger businesses, many were brought to their knees and were forced to shut down production lines, invoke layoffs and miss loan payments due to lack of reliable delivery of supplies.
Business owners scrambled to order from alternative suppliers only to be turned away. And that’s because suppliers were only taking and attempting to fulfill orders from existing, good customers. Ouch.
Unfortunately, buyers are acquiring businesses intending to gain market share, not to maintain the status quo. Therefore, as your company grows, the importance of your supplier pool becomes even more important. A lack of available alternative suppliers can and likely will severely hamper growth or even possibly cause your business to shut down.
How Employee Concentration Affects Business Value
Apart from customer and supplier concentrations, critical employee concentration is perhaps the most concern for buyers and one of the most common risk areas for small businesses. The smaller the company, the more likely this problem will occur.
Small businesses often rely heavily on the entrepreneurial spirit of their CEO/owner, who may be primarily responsible for multiple key functional areas. Situations like this are not uncommon, but over-reliance on one person increases the risk and perception of your business. All else being equal, the market places higher value on companies with more complete management teams, including talented individuals leading the key functional areas of sales and marketing, finance, engineering, and operations.
Developing a competent management team who shares the founder’s vision for growth and increasing the value of the business is one of the most difficult as well as the most financially rewarding goals to achieve for your business. Doing so reduces this risk and greatly improves business value.
Concentrations have multiple negative effects on the value of the company when present because they are an indicator of elevated risks.
First, concentrations frequently entail the danger of declining revenues as a result of a reduction in customer demand or the company’s inability to continue providing or manufacturing its products.
Second, they can signal a ceiling on revenue growth due to constraint on the company’s capacity for selling product or manufacturing production.
And lastly, without a well-trained management team in place, the absence of the founder may present a situation where the business will no longer be able to sustain and grow its revenue, effectively utilize its personnel, efficiently operate and generate profit for its shareholders.
By focusing on reducing these three concentrations in your business, you will automatically increase the value of your business.