It’s critical to view all aspects of your business from the buyer’s point of view. The buyer of your business is paying you for the future profits generated from your existing customers, so the buyer has a high level of interest in reducing the risk associated with those sales. The best way for you to reduce that risk in their mind is through a diversified customer base. If there is too much customer concentration, it can impede your ability to sell the business at all or result in a less-than-desirable deal structure, which might include making a significant portion of the purchase price contingent, or mandating the seller to carry a note for a large portion of the sale price. As a seller, aligning your financial well-being with your former company and its customers for an extended period is probably the least preferred scenario.
With that said, it’s important to establish a diverse customer base, ensuring that no individual client contributes more than around 10% of total sales. Consulting with a trusted advisor regarding industry-specific customer concentration details is essential. A broad client base serves as a protective measure, guarding the company against potential setbacks caused by the loss of any single customer.
Attaining this goal can pose challenges, especially when building a business with limited resources and relying heavily on one or two major customers for financial support. In such a scenario, it becomes crucial to contemplate taking the following steps: (i) reinvesting profits into expanding capacity to facilitate the development of a more extensive customer base, and/or (ii) achieving diversification by acquiring smaller competitors.
High customer concentration can prevent a third-party sale of an otherwise attractive company. Witness the situation with Double L Boilers, a hypothetical case study of a profitable fabricator and installer of commercial heating systems.
Their EBITDA exceeded $3 million per year, a strong management team was in place and all systems were “go.” So thought Jim and James, its owners, until the investment bankers analyzed the company’s customer base and discovered that more than 85% of the company’s revenues and profits derived from eight customers. The owners didn’t quite understand why that fact presented a problem. After all, those eight customers were long-time customers and provided a steadily increasing cash flow to the business. Jim asked, “Why should we try to diversify when it is all we can do to keep up with the new business from our existing customers?”
Their most attractive buyer (a Fortune 100 company) provided the answer. It insisted on meeting with each of the eight customers to determine their willingness to remain with the company after it was sold.
Jim and James objected vehemently. “What will our loyal customers think and do? If they assume that we’re selling our business, will they stay as customers? What happens if we don’t end up selling and they leave anyway?”
These owners realized that losing even one customer would be a financial setback and losing two or three spelled disaster. Not only would the sale fall through, but the company might be thrown into a financial tailspin. These same insights prompted the potential buyer to demand the interviews. They were not prepared to pay $20 million for a business whose customer base and cash flow might well decrease by 15% to 45% overnight—simply because the business was under new ownership.
Jim and James faced a true dilemma: the only way to pursue the sale was to allow this buyer to meet with their customers. If they refused, the buyer would most likely back out. If they allowed the buyer to meet their customers, the sale might fall through for totally unrelated reasons, and their relationships with its customers might be irretrievably harmed. Even if the sale did close, their customers potential loss of confidence might cause them to bolt and jeopardize their earn-outs. Had this business had even 20 customers, the situation would not have surfaced.
In the end, Jim and James did allow the prospective buyer to meet with their customers. All indicated that they would remain customers if the service level remained high. As expected, the buyer’s terms included that the sale price would be reduced on a percentage basis if any customer left within 30 months after the sale. Tough terms, but the only ones that the buyer would accept.
As this case study illustrates, it’s very important to establish a diversified customer base early in the process of preparing your business exit.
If you have any questions about increasing the value of your business prior to your exit, please contact us to discuss your particular situation. We can help guide you through the process of identifying the current value drivers in your business and creating a road map for increasing value to meet your overall exit objectives.