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One of the greatest risks any buyer faces is what will happen to the business’ best customers post-sale. Will the top customers celebrate the founder’s great accomplishment or maybe decide it’s a good opportunity to negotiate better pricing or payment terms with the new owner? Or worse yet, will they be spooked by the new owners and find an alternative vendor?
Astute buyers measure this risk quickly. Typically, one of the first questions experienced buyers ask the business broker is about the presence or lack of a customer concentration.
For the business owner considering the sale of his business in the near future, having a clear understanding if a customer concentration exists is vitally important. In fact, the lack of a customer concentration is a great selling point.
When a customer concentration does exist, how is this valid objection overcome by the seller? How does the business broker get such deals done? And how would a bank or the SBA Lender deal with such a situation?
Today, I sat down with one of our Featured Advisors to discuss this matter. Matt Gilbert, a partner in the Business Brokerage firm Gilbert & Pardue Business Advisors weighs in with his thoughts on this subject.
How often do you run into a business owner who wants to sell his or her business with a serious customer concentration issue? And when you do, does the business owner understand the problem exists at all?
Matt explains that his business, GaP, is an “upper-small, lower-middle” market intermediary, meaning they represent clients having between $500k – $10M EBITDA. They engage as both buy-side and sell-side representatives with about 85% of their work being on the sell-side. He mentions this to demonstrate that he has exposure to the way both parties in a transaction view this issue.
Matt has the opportunity to speak with well over 100 business owners each year who are considering selling their businesses, and he estimates that roughly 25% of them have an issue with customer concentration in one form or another. Many people don’t realize that customer concentration comes in many forms such as:
- Too large of a percentage of your business is with one customer
- Too much of your business is concentrated in your top 5 or 10 customers
- Too much of your high margin work is with one customer or group of customers
- A large customer’s work is “customized” and doesn’t flow through your normal channels
- Your largest-volume customers are your lowest-margin accounts
Matt often finds that business owners understand the problem of a single account dominating revenue. However, equally as often, he finds that business owners do not understand (1) where their best margins come from and why, (2) that the top 25/30/50% of revenue is with only a handful of customers, and (3) that customization is a form of concentration if it isn’t scalable.
Therefore, “masked concentration” seems to be a pervasive issue with business owners AND their advisors who either don’t do pre-engagement research or who don’t understand a buyer’s risks well enough to dig beneath the surface. Matt’s firm refuses to engage in representation until they have performed an extensive financial review, business review, and close-ability analysis.
Matt emphatically states that the best brokers won’t list a business until they know it well enough to understand its strengths. However, it is far more important for your broker to understand your business’s weaknesses and potential obstacles to generating enough interest to foster competition amongst real, active buyers possessing the wherewithal and desire to close a transaction of your size.
Looking under the financial and business hood is a vital duty for a broker (who is acting as your representative) to gauge whether or not he/she can achieve your goals. Part of that duty includes having a clear understanding of customer concentration, retention, pay habits, reason(s) for purchasing, etc.
How would you define typical customer concentration issues that you’ve encountered in your work with business owners?
Matt comments that they routinely see smaller firms relying too heavily on one account for a significant portion of their revenue. Sometimes it helps to think of it this way. Think of the concerns you might have if you relied too heavily on one key vendor to produce your results. You might risk material delays; workforce issues such as strikes, payment, or solvency concerns; the domino effect of poor-quality control; performance risk; etc.
The same is true of a buyer’s risks when looking to purchase your business. If you rely too heavily on one customer or group of customers to produce your results, then the buyer must adjust their plans and purchase offer to compensate for assuming those risks. This can be in the form of moving funds from guaranteed to contingent or by flat out reducing the price they are willing to pay or both. Doesn’t it make sense to figure all of this out BEFORE you begin attracting buyers so that you are able to understand and control the process and its outcome?
Perhaps you have the time and resources to remedy concentration issues and could really benefit from delaying the sales process. Sometimes making this choice pays handsomely by reducing the risk a buyer must assume, which in turn produces confidence in their purchase. Make no mistake, buyers reward security and confidence.
Aside from the obvious, if a business owner has time to address their customer concentration issue before selling, are there other things that could be done to resolve the matter or mitigate the situation?
Matt points out that a good broker will flip the negative to a positive. This is done by knowing the business represented inside and out and then figuring out a strategy to frame the issue into a positive. An example might be: “Because of the limited human resources capable of performing this work, we made the strategic decision to stop doing business with our lowest margin accounts. This allowed us to focus those resources on responding to the needs of XYZ Company because they understand the value we bring. Thus, we are making a business decision to pursue a higher margin by taking the risk of concentrating with XYZ Company”. Then show XYZ’s stability and growth, etc to demonstrate the wisdom.
Another way to counter the risk associated with a concentration issue is to have the customers representing the risk enter into a contractual agreement for the continuance of the services, prices, or products. Make sure the agreement is transferable or this may backfire on you. But there’s no substitute for a contractual obligation to do business with you when arguing that the concentration is not problematic.
In prospecting for buyers of your business, you can seek out businesses who have a strategic reason not to be uncomfortable with the issue.
Buyers falling into this category might include:
- Those with the desire to be in your geography
- Those who may have a complimentary service or product and so can open up your offering to their customers and reduce the concentration
- Those who aren’t doing business with the customer or group of customers in which you are concentrated
- Those with more resources and capacity to add new customers, thereby reducing the reliance risk
What should business owners/sellers know about how a customer concentration affects buyers who need to source capital from a bank, commercial lender or even the SBA to purchase the business?
If you’ve read this far, you understand that customer concentration is a problem. Matt points out that the truth is that lenders see it as a problem, too. They will be relying on the buyer’s continuing to do business at the same or greater volume with the same or greater customer base in order for the buyer to service debt.
Great attention must be paid to getting a lender comfortable with the risks a buyer takes when purchasing a business. Any component that could result in reduced earnings will be scrutinized. To combat their fears, it helps to produce a guarantee that sales will continue. If this is not a possibility, it helps a lender to believe in the buyer as an operator if that buyer comes right out and articulates the risk. Along with articulating the risk, it helps tremendously if a buyer has a compelling plan to address it by diversifying away from the risk, adding resources, adding new customers, etc.
No one knows a business better than its owner. Therefore, an owner and his/her team can help the cause by addressing these issues and potential remedies internally and having plans, data, and statistics prepared in case the chosen buyer will require a lender to get the deal closed.
Is it ever possible to sell a business with a serious customer concentration problem? If so, how can this selling obstacle be overcome?
Matt assures us that not only is it possible, it is common.
Buyers deal with the issue by:
- Making funds contingent on customer retention
- Keeping the seller involved to help transition the customers
- Rewarding employees for reducing concentration by introducing new customers and products
- Merging a high-risk acquisition into a low-risk and diverse business unit
- Renegotiating prices, volumes, and terms with customers to better suit the buyer’s risk appetite
In the end, Matt reminds us that only one buyer can buy your business. It pays to show it to a number of qualified buyers to find a really good fit. When this happens, issues like customer concentration can be worked through without killing the deal. A win/win/win/win (you/employees/customers/buyer) deal is always best! A good intermediary/broker who takes the time to learn your business and who creates a plan to overcome buyer’s obstacles is worth every dime earned.