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Why customer concentration affects a commercial sales transaction

Few owners recognize the huge impact customer concentration has on the sale of their business. Customer concentration represents a significant hurdle and will affect the sellability, valuation and negotiation structure of a business for sale transaction. Not only will it create problems in the qualification of buyers, but it will affect the ability of any potential buyer to obtain financing from third parties to complete the acquisition. Determining whether customer concentration is present in a business is a critical element of the succession planning process.

Customer concentration is a situation where one customer represents a significant portion of revenue or when the business has a very small customer base. Depending on the expert consulted, the exact percentage for a concentration to exist varies. In most cases, it is recognized when a customer accounts for more than 10% of sales or when the top five customers comprise more than 25% of a company’s revenue. In either situation, great risk is created by a lack of diversification and steps must be taken to mitigate it years in advance of a planned business exit.

When evaluating the sale of a business, it is important for an owner to recognize that their customer base has a significant impact on the business value of the business. A large and diverse customer base where there are a large number of customers contributing to business revenue will achieve higher transaction value as it reduces the risk of a significant drop in profits if a customer or business is lost. particular industry. The segment that the company serves is experiencing economic difficulties.

In addition to a lower selling price, businesses with customer concentration issues are more difficult to market for sale. For high street business transactions (those with adjusted earnings of less than $2mm) third party financing is used in most cases. Companies with high levels of customer concentration are very difficult to finance. Lenders may provide only partial financing, offer suboptimal terms, or reject the loan altogether. In situations where third-party financing is not available, the pool of available buyers is significantly restricted and the terms of a deal could be heavily weighted on a contingent gain based on retention of revenue earned by larger customers. “We typically don’t want a client concentration of more than 10% when we’re considering financing an acquisition. Higher levels are possible with a lot more explanation and supporting documentation, but it’s still a major concern,” said Steve Mariani, president of Diamond Financial Services.

Finally, the concentration of clients will have a direct impact on the structure of agreements for the business sale transaction. Buyers will strive to overcome customer concentration risk through a variety of ‘performance-based’ deferred financing methods. For example: Suppose both parties agree to a transaction price of $900,000 based on $300,000 of adjusted earnings (a multiple of 3x). If the key account in question represents $75,000 of the $300,000, this would represent $225,000 of the transaction price. A buyer will strive to isolate the $225,000 component to ensure that the proceeds are sustained after the sale. After a period of 12 months, if the customer and the income are still valid, the seller would receive the funds. If the identified customer and related revenue were lost during this period, a price adjustment would be made.

In situations where the buyer is unable to obtain financing for the transaction due to customer concentration issues, the seller may have to accept a “contingent profit” on income derived from larger customers or, worse, also may have to finance a significant portion of the “non-contingent purchase price” negotiated with buyers.

Contingent payments can be structured in a variety of methods:

Consume:

Allocate part of the purchase price to payments made over a period of time conditioned on the retention of specific customers or the achievement of specific revenue goals.

Deposit:

A percentage of the purchase price will be held in an escrow account for a specified time.

Seller-Financing:

The seller would be responsible for financing a significant portion of the purchase price through a seller’s note. The seller’s note could be structured with contingencies for income derived from larger customers.

With any of these deal structuring techniques, the seller cannot be expected to guarantee revenue in perpetuity, and if the transaction price is based on retaining one or more key customers, the seller may require a more active involvement in the maintenance of the relationship with the client during the term of the agreement. Obviously, this brings additional complexity to the transaction.

In most cases, buyers will seek to discount the amount they are willing to pay for a business (with a high concentration of customers) unless they are assured that the risk is low. While the obvious strategy to reduce customer concentration risk is to diversify and increase the business customer base, there are a number of situations where customer concentration does not represent a significant risk or could be mitigated.

Customer contracts:

Having a current contract will not eliminate all risk of losing a customer key, but it will give the buyer the security that revenue and profits will continue after a change of ownership. When it comes to customer contracts, it will be important to understand the ability to assign or transfer. In many cases, a stock sale vs. the sale of assets is chosen to preserve these contracts.

Barriers to Entry or Exit:

Companies may have intellectual property, product expertise, or patents that create competitive advantages that impede competition. Others are located in geographically remote areas where supply benefits discourage customers from changing the relationship. Finally, there could be significant capital requirements for manufacturing and tooling or agency approvals (pharmaceutical or government contracting industry) that create a barrier to entry for potential competitors.

Provide a variety of products and/or services:

Having a broad relationship with a key customer where the relationship is not based solely on one product, one location, and one person lowers the risk that a single change will fundamentally affect future revenue stream and account continuity.

Economies of Scale or Synergies:

The acquisition can be carried out by a strategic buyer that brings new products/services to the company, a wider geographical distribution or economies of scale in production. Any of these elements would help reduce the concentration of revenue risk that an identified key customer would represent for the future organization.

Summary

Businesses that have high levels of customer concentration are inherently risky and it is important for the owner to appreciate this concern from the perspective of a potential buyer. Ultimately, the buyer only seeks to retain customers who have contributed to the success of the business and are factored into the valuation and price of the transaction. From the position of a buyer, some logical questions and concerns would be:

  1. How does the value of the business change if a customer representing 10% or more of revenue and/or profits is lost in the first year?

  2. How easy would it be for the customer representing the customer concentration concern to leave the business?

  3. What unique situations exist within the business to preserve the customer relationship for years to come?

  4. What are the logical steps and corresponding costs to mitigate customer concentration risk?

  5. How do I achieve a win-win transaction? Protect me, the buyer, against the risk of short-term loss of income while providing the seller with adequate compensation for the fair market value of his business?

While the risk may not be completely eliminated, there are a number of situations where customer concentration is more acceptable and a proper explanation should be provided to the buyer as soon as possible. Coming to the forefront of this potential challenge is critical to achieving a win-win deal. When there is good communication and there are two fair and reasonable parties at the table, a number of structuring options are available, where necessary, to mitigate risk and negotiate a fair and reasonable transaction price. Obviously, the best approach for a prospective business seller would be to develop and implement plans to reduce any elements of customer concentration years before going out of business. Eliminating this type of risk is just good advice for any small business owner, regardless of whether a sale is contemplated.

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