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A Company That Didn't Sell: Business Valuation and Customer Concentration

Updated: May 17, 2020

Some of the best lessons in the drivers behind business valuation come from the deals that didn’t get done. A few years ago, we were working on behalf of a buyer and we had identified what seemed to be a strong company in a growing industry. They had put in place some strong processes and their culture was bringing them in the right direction. Their customers were A-list household names that you would instantly recognize if I said them. It was fun getting to know them during the diligence process.

But there was a problem… three customers made up 80% of their revenue. We struggled with how to properly account for this when forming our valuation thoughts. After several internal debates we finally arrived at a structure that we thought pretty fairly distributed the risk of a customer departure from the seller to the buyer over time. A customer departure would mean a cancellation of a part of the seller note and the amount of that cancellation would decline for every month a customer didn’t depart. The logic was that if a customer left the day after a transaction was announced, that probably had nothing to do with the buyer’s ability to run the business, but instead had more to do with the fact that the buyer was simply not the seller (with whom the customer had a strong personal relationship). If, however, a customer left after a year, this was more than likely because of the buyer’s ability to run the business and wouldn’t, at that point, have much to do with the seller.

The seller wasn’t ok with our LOI and the deal never did happen. When we checked in on the company a couple of years later, we learned that the owner of the company still hadn’t been able to sell his company to anyone.

We use this story regularly today when working with buyers of companies or working with owners looking to boost the valuations of their companies. Customer concentration is one of the key components of company specific risk (CSR) that increases discount rates and lowers any discounted cash flow valuation. Companies with otherwise identical size and cash flows can end up transacting for significantly different amounts (or not at all) if they have a customer concentration issue.

The time to start working on your customer concentration is now. It can take a while to adjust your model to a point where this is less of a factor. Specific exercises can be done to dive into each of your company’s offerings to determine which have the ability to scale to more customers and which might not offer the potential to breakthrough the customer concentration valuation hurdle.

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