In our previous post we discussed the risks of high customer concentration, which can have a drastic impact on the valuation of your business should you decide to sell. If you are thinking about selling your business now or in the future, there are other forms of concentration such as vendor, geographic, industry and employee concentration that can also affect valuations depending on your size. Let’s look at the risks of these in more detail.
1. Vendor Concentration
Vendor concentration is when a company relies on only a handful of suppliers. If any one of them goes out of business or substantially raises its prices, (or lowers margins) the company relying on it could find itself unable to operate or, at the very least, face a severe rise in expenses. This dependency can affect any size organization and the only way to alleviate this is to diversify amongst vendors. I have seen more than one software vendor bring sales and consulting in-house, leaving a VAR or MSP in the cold with relatively little notice. Even if you work with a large vendor who only works through a sales channel, you are always vulnerable to margin changes. Find other solutions or add-on products that can round out the vendor solution. Over time, this can account for more than 50% of your total software sales.
2. Geographic Concentration
You may also encounter geographic concentration. If your customer base is concentrated in one area, a dip in the regional economy or a disruptive competitor could severely affect profitability. Small local businesses are, by definition, dependent on geographic concentration. But now, with cloud solutions, you can diversify your customer base and not be so dependent on the local community for your revenue. Again, this is a slow transition, and it is also a switch from sales to marketing as you need your website to do most of the sales, but this transition is important. One of my companies had a high concentration of customers in San Diego because we were very focused on life science companies (of which many reside near the local university) but, over time, we were able to attract more life science companies in other parts of the US as our referral network took hold.
3. Industry Concentration
While so many industry analysts and channel heads have been preaching industryconcentration for the last ten years to increase company value, these last twelve months have proved otherwise for companies focused on the retail, travel, and entertainment industries, to name a few. I never like to put all my eggs or have all my customers concentrated in one industry basket, and COVID proved this out. My rule of thumb has been to never have more than 35% of your customers in one industry. That is a high enough number of customers to say you have expertise in that industry, but low enough to not be burned by a collapsing industry. If possible, pick a second industry that is far enough removed from the first, but can still take advantage of similar products and services. Good advice regardless of size.
4. Employee Concentration
And finally, employee concentration. This issue is generally geared toward smaller organizations; however, I have seen large companies (over $30M in revenue) be paralyzed by this as well. What I really mean by that is: having one employee who either technically understands/maintains or runs most of your business. What would happen to your business if that key employee left or became ill? He or she is your single point of failure. Would your business suffer greatly? How long would it take for you to recover?
Many years ago, when I had my ERP/CRM consulting firm, I was beholden to one employee who really understood manufacturing well. He was my Director of Consulting and ran all my manufacturing projects, and my clients absolutely loved him. No one else could do the work he did as manufacturing is a very specialized field, and not many people understand it well enough to implement those types of software systems. Well, he and two other employees decided they were going to leave and start their own competing firm. And of course, they timed it right after we sold a huge manufacturing solution to a large customer. Sure, I had non-compete language in my employee agreements, but who is going to stop a customer from leaving if you no longer have the team to support the implementation? I ended up having to hire him as an independent contractor to finish the work while I looked for his replacement.
Lesson learned: never let one employee, no matter how senior, be the one and only person your customers have contact with, and never let one person be the sole source provider of a solution. Savvy buyers will see this or see that you have a very thin management team and–unless they have their own team to support this solution–it may affect your valuation.
Whether it is customer concentration or another form of concentration, just know it is usually NOT a quick fix. Sometimes these can take years to overcome. But, if you have the time, it is well worth the effort to fix. Any of the concentrations above can reduce your EBITDA multiples, which can truly lead to millions of dollars. Take the time now, go through the exercise of determining your sales by customer, and start there. Then, when you are finally ready to reveal your financials to potential acquirers, you can put them at ease that you’re well within accepted norms for customer concentration and others mentioned above.
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