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21 Oct Increasing Business Valuations for M&A: Diversify the Customer Base

Each businesses with which we work has a different tail that wags the proverbial dog. Some companies operate with a very small client-base with sky-high margins, while others work in the arena of razor-thin, making up for the lack of margin by building a scalable enterprise. Regardless of the model, the product or the service being offered, every target becomes more inviting when the customer base is diversified. I’ll say it again differently and perhaps more clearly, a diversified customer base can significantly increase your business valuation.

The biggest downside to the company with a less-diversified customer-base in the inherent risk associated with a liquidity event. Companies with less diversified customer portfolios often run into extreme cash flow issues after deals are done and management has transitioned. It parallels the simple mantra of keeping too many eggs in a single basket.

"I've diversified your money by turning it into butterflies."

The best private equity firms seek companies who have less downside risk by having no single client accounting for >10% of gross sales. In addition, having a multiplicity of customers across a broad swath of industries also helps to mitigate downside risk. Such companies have differing Betas and are less affected by similar economic conditions.

Customer Data: Understanding Your Clients 

When potential acquirers arrive for due diligence chats with senior management, many business owners and entrepreneurs fail understand the depth to which investors may want to know about the client-base. Another way to increase your business valuation is to ensure you have an accurate understanding of the customers. Here are some fairly standard qualitative and quantitative measures for fully understanding a potentially complex customer ecosystem within your business.

  • Understand gross revenue by customer for every time period, including months, quarters and years.
  • Understand the competitive advantage of your customer-base. Can they be used for up-sell and cross-sell later?
  • Follow and glean trends from customer databases, especially if you operate an eCommerce business looking to sell your company–this information should be more readily available from advanced CRM systems. If you don’t have such in place, include them in the business plan prior to prepping the company for sale.
  • Know the sector(s) and region(s) you serve and understand how you do things differently and better than the competition.
  • Pay close attention to accounts receivable (AR). Your AR will be very telling of the types of customers you have and the ones with which you may be struggling. Aged AR never looks good from the acquirer’s perspective.

Small Business Customer Concentration Issues

Perhaps one of the greatest flaws of small businesses looking to sell is the fact that many smaller companies have customer concentration issues. Addressing such value-detractors before attempting to find a qualified buyer for the company can help to significantly increase the value of the businesses, providing the entrepreneur with a much more gratifying liquidity event.

From the potential acquirer’s perspective, having any one customer account for greater than 10% of overall sales represents a large risk to the sustainable cash flow of the enterprise. Here are some considerations acquirer’s will want to know and potentially have mitigated prior to putting an offer on the business.

  • What types of repercussion could be expected if a major customer jumped ship?
  • What types of contractual agreements protect major customers from walking away after the transition of the company?
  • Does the customer have an exclusive relationship with the company?
  • Is there longevity of relationship with the customer which could prove dead once the business is sold?
  • What type of co-dependence opportunities are in place with the customer (i.e. does the business service multiple locations and provide multiple products and services along the customer’s value chain?). In other words, who has the greater power, the customer or the supplier?
  •  Is the customer locked-in with some form of preferential contract or pricing obligation that would keep them from getting skittish if a deal were to be executed?

Diluting Customer Concentration Risk

Buyers will be concerned whenever there is too much customer concentration risk. It can significantly impact the value of the business and the acquirer’s desire to buy the company. Sometimes there are no easy ways to immediately reduce customer concentration risk. However, in some cases, focusing on growing sales and growing the customer-base is the best executable plan to mitigate customer concentration risk. This is a completely different discussion for a different time, but the bigger your customer-base, the less you have to worry about low valuations and lack of interest from potential buyers.