IMGCAP(1)]If you have clients whose company customer concentration as a percentage of sales looks anything like the 80/20 rule—that is, 80 percent of revenue comes from 20 percent of customers—their company’s value could be in the tank.
In this economy of fickle customers, investors are paying increased attention to customer concentration ratios. If most of your client’s revenues come from a small number of customers, investors are more likely to put that company into the high-risk category. It’s essential to take immediate action to broaden the customer base so the company’s value can be maximized to ensure its future success.
This landscape has spawned not only a drop in valuation multiples, but also a great deal more scrutiny into middle market companies’ earnings drivers. Rising to the top of many risk premium adjustment lists is customer concentration. Lenders and business investors have adopted a new middle-market transaction service called quality of earnings to help them truly prove the bottom line is accurate and sustainable.
The questions are simple: Where are sales coming from? Who are your customers? How sustainable, protected and accurate going forward are your figures?
Here are five ways CPAs can counsel their clients to reduce high customer concentration and increase their company’s value:
1) Diversify the Base
Help your client find, create, or buy different lines of products and SKUs that can be sold to the same consumer base by using different distributors, retailers or wholesalers. Try new channels at various price points and locations. Try to bundle several products and services into a single package deal, like McDonald’s Happy Meal, or online retailers. “Nice shirt, need a tie? How about a deal on socks to go with those fancy new shoes?”
2) Make an Acquisition
Find another company for your client to merge with or acquire—one that has a complementary product or a wider distribution network that will help spread customer concentration risk across a wider segment. In fact, many merger and acquisition deals are entirely based on this premise in the first place. According to research at the University of Florida, more companies are coming to market after the 2008-2009 crash, opening the door for a quick way to diversify the customer base and product line. CPAs can help identify potential M&A targets that make sense for their customers’ business.
3) Phase out High Customer Concentration Accounts
High customer concentration often comes with low margins. Owners justify the high volume/low profit as a means to keep things moving. Unfortunately this attitude simply cannibalizes future business capacity to service higher-margin customers. Spending too much money and effort to service a single high-volume customer with specific needs such as expensive manufacturing equipment, RFID packaging, increasing “return” credits or impossible delivery deadlines can lock your client in, and permanently reduce the capacity to service future customers. Unless a high CC customer is ready to “guarantee” your client’s business a lifetime of sales, or unless the business has a very high barrier-to-entry as an integrated supplier might have in the auto industry, look to find a strategy to phase out high-volume, low-margin customers with more diverse and profitable ones.
4) Pretend You Want to Sell the Company
Even if your client is not actively looking to sell, it is an established fact that owners who prepare to sell their company at least 12 to 18 months before they seek a buyer have developed and put into action a plan to clean things up. Not unlike preparing to sell a home by repainting inside and out, these sellers pass past due A/R to a collection agency, pay off debt, streamline profit and loss expenses, and focus on increasing and incentivizing more sales and profit across a wider customer base. The goal is for no single customer to be more than 10 percent of sales. Many sellers, by the end of this exercise, ask why they didn’t take such action sooner. Advise your clients to act like they are internally committed to getting the best price for their company and shareholders. The outcome of putting such a faux sale action plan in place today can immediately help identify ways to fix high customer concentration issues without having to sell the company.
5) Internalize the Problem
If your client does have a high CC and can’t give it up, there’s still some hope. Let’s say the client is like thousands of Wal-Mart suppliers, using that one customer to keep the lights on. What can you do, if anything, to help your client prevent a sudden loss? The answer is still to diversify sales; however, do it within the walls of the customer itself. Is it easy? No. Can it be done? Yes. If your client’s contacts within his customer’s own purchasing organization can reach across more lines of business, and away from any single concentrated buyer group or single key decision maker, your client may be able to buy more time. In fact, lenders and investors do understand these situations and how to get out of them. They simply won’t increase your client’s company value or make a loan when they believe there is a high CC risk and something could go wrong. Instead bankers will tend to impose a substantial discount or penalty rate leaving your client to take it or leave it.
Is high customer concentration a new phenomenon? No. But in a poor economy it is a growing risk that any business takes should a key account walk away. The five actions outlined above are preemptive ways CPAs can help their clients avert that danger. Ask your client, “If you lose a key customer, will that seriously jeopardize the business and staff you have worked so hard to build?” If the answer is yes, you now know there is something you can do about it.
Rick Andrade is a managing director at Calabasas Capital, a Los Angeles-based investment banking firm helping to buy, sell and finance middle-market companies. He has Series 7 and 63 FINRA securities licenses, and is also a real estate broker and a volunteer SBA/SCORE instructor.
