Customer Concentration and How It Impacts your Purchase Price
Being a business owner continues to be a great career path for go-getters that want the independence of being their own boss alongside the ultimate risk/reward compensation structure. While you can have a great career running your own business, there will (hopefully) come a time when you need to sell it. When you’re actively looking to sell your business, various factors can influence the purchase price. One factor that any buyer will consider is your customer concentration.
What is Customer Concentration?
A customer concentration report will outline how much of your revenue, accounts receivable, and profit comes from a certain customer. Generally, a buyer of a business will want to see this for all of the key accounts in your business. While some organizations may have very fragmented sales, there are situations when a business may have a high concentration, and just a few clients make up 50% or more of the business.
In some cases, a higher concentration could be a strength for a business. If you have just a few high-credit customers under long-term contracts, it could provide an assured level of revenue each year. However, in the majority of situations, high concentration is considered a risk and can impact the price of a business.
How a High Concentration Can Impact Purchase Price
While you may have had the same significant customer for a long time, many business buyers will perceive a high level of concentration as a risk. There are various reasons why high concentration could impact the purchase price and acquisition of your business.
Potential Loss of Business Overnight
One of the reasons that a high concentration can impact the value and acquisition price of your business is that there is the potential to lose a considerable amount of money overnight. If someone is looking to purchase your business, they may find there is an opportunity to improve cash flow and performance. However, they will rely on the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) that you have in place and that they can count on. In many cases, the valuation will be calculated as a multiple of your EBITDA. If you have a high concentration on one customer, there is a chance that the customer could be lost once the purchase of the business takes place. Due to this risk, your business value will likely be discounted.
Perception of Limited Growth
Another reason your purchase price could be reduced is if you have high concentrations in place because there is a perception of limited growth potential. Anyone that wants to buy a business will be more intrigued by one that has shown evidence of growth over the years. This will include wanting to see both an increase in annual revenue as well as an increase in the number of customers. If you do not have evidence of continued growth in the number of customers, buyers will consider it a sign that there is less potential. If you used to have lower levels of concentration and have had higher customer churn and lost business in the past, it could also impact value.
Less Bargaining Power
Those looking to acquire your business will also believe that you have less bargaining power if you have high concentrations. If your business only has a few key customers, you will need to do all that you can to meet their needs and expectations. While it is always important to treat your customers well, this could mean reducing prices considerably to the point where you struggle to make a profit. It may also be harder to pass on increases in expenses if your operating costs rise. This is particularly true with larger “gorilla” clients that may be accustomed to pushing vendors and businesses to reduce rates or expand services for no additional revenue. As this risk is always looming with a concentrated customer base, it will lead to a discount on your valuation.
Reduced Financing and Capital Availability
In most situations, a business or investor will want to utilize leverage when making an acquisition. This can mean taking out a bank loan or raising money from outside capital. Whenever any institutional investor or bank assesses the opportunity, they will always focus on sources of revenue and customer concentration. If you have a very high concentration with a few customers making up the bulk of revenue, these institutions will likely reduce their leverage based on cash flow. Further, if a third-party enterprise valuation is completed, higher levels of concentration will result in a reduced value due to the aforementioned risks.
How to Maximize the Sales Price of your Business with High Concentration
If you are looking to sell your business soon and you have a high level of customer concentration, it could impact your business. However, there are tips you can follow that can help reduce concentration and maximize the sales price.
Improve Sales to New Clients
One of the best ways to maximize your sales price would be to reduce your customer concentration. There is a chance that you have high concentration because you have been complacent in recent years. Fortunately, by working hard on sales and marketing, you could bring in more customers to your business, which will naturally reduce concentration.
For example, if your business has revenue of $10 million per year and you have a 60% concentration, increasing sales by $2 million from brand-new customers would immediately reduce the concentration to 50%. Increasing sales by $5 million would reduce the concentration to 40%.
Hire an Advisor
If you are struggling to sell a business due to high concentrations, it can also be a good idea to hire an M&A advisor. The professionals can properly assess your business and advise on mitigating the high concentration. An advisor will offer various services to help you prepare your business for sale. This can include giving tips on how to expand your revenue sources, find new customers, and expand services that will naturally reduce concentration risks.
