There are two main types of value-killers that can impact both the sale and valuation of a business:
- lack of separation of owner from the business; and
extreme customer concentration.
In this article, we will examine why both of these situations create critical problems and what an owner can do to alleviate them over time.
Transitioning a business is difficult under any circumstances but there are two key factors that can negatively impact the transferability of your business if you don’t monitor them and address them in a timely manner. First, the lack of separation of owner from the business is the largest impediment to selling or transferring it. Second, a high concentration of customers is the next biggest value-killer an owner can face when trying to sell their business. Combine the two of them, and you may very well have a business that cannot sell. What is the value of such a business? A business that is no longer a going concern can only be valued at liquidation value. At best, this liquidation can be orderly and an owner can obtain as much as possible from the sale of inventory, fixed assets, and anything else that can fetch some value. The worst-case scenario is the business suffers through a forced liquidation where a Company’s assets are auctioned off at pennies on the dollar.
Before we proceed, let’s give examples of what each of these value-killers might look like in a real-life scenario. Let’s assume David has owned a business for the past 20 years. His business has been successful with steady growth and has allowed him to take home a generous salary along with dividends. The business employs about ten people: two people in the warehouse, an office administrator, two salespersons, an accounting manager, and four office and accounting staff. David plays an integral role in the sales and marketing process in the Company, attending many sales calls along with a strong belief he must be present to close all deals. David also considers himself somewhat of an operations specialist and spends every day reviewing and approving orders and negotiating all deals with his suppliers with whom he has a long-standing relationship. Sadly, David has complained to his friends that he can never take off even a week from work because he has to handle important calls and send emails. To add to David’s problems, about 50% of his revenues come from three customers with whom he has had a long relationship but there are rumours going around one of his customers will be bought out shortly by a company who regularly buys from one of David’s largest competitors. He is worried that he will lose the entire business despite maintaining a great relationship over the years.
Under such a scenario, it is clear that while David’s business has been personally very lucrative to him over the years, there are serious transferability issues with his company, largely due to extreme owner dependence (that is, the business cannot operate separately from him) and high customer concentration, so much so that the departure of even one customer may have a serious detriment to the financial state of David’s company. Even if the proposed merger with his customer does not go through, the risk that this may happen in the future is something that most likely will negatively impact the business value.
The good news to David is that both issues of owner dependence and customer concentration is something that can be addressed over time. It’s important to realize that an issue like owner dependence is not a binary situation but rather can be assessed along a continuum. The owner has to realize that intellectual capital can’t be stuck in their head but must be something that is both accessible to a prospective owner and understandable. Similarly, customer concentration issues cannot be solved overnight but given enough priority and time, revenues can be diversified enough to lower company-specific risk.
Risk is the key word here because both owner dependence and customer concentration create risk in the eyes of a prospective buyer. Make no doubt about it, risk means a lower valuation (or potentially no sale at all if no one is willing to assume that risk). Just like investors are told time and again to diversify their portfolio of stocks, so too should you diversify your portfolio of customers. Meanwhile, separating yourself from the business allows you not only more freedom to spend on bigger picture issues, it allows the possibility of someone else to envision the ability to take over your business, thus creating its transferability.
From a valuation perspective, these risks can be expressed in different ways. Company specific risk is that which is unique to each business based on certain characteristics. So, in our example above, the company specific risk of David’s company would reflect a lack of separation between owner and business along with accounting for the customer concentration issue. Sometimes valuators account for owner dependence issues through a “key person discount” that is applied against a preliminary equity valuation. Either way, the issues of owner dependence and customer concentration only serve to lower the value of a company.
Addressing the Problem
How would an owner go about fixing these problems? First, it’s important to note that these problems can’t be fixed overnight. Second, the business owner has to be mentally prepared to not only delegate responsibility and remove themselves somewhat from the running of their company, but that solving these problems requires teamwork. That team may consist of not only trusted advisors such as your accountant, lawyer, or financial advisor, but more permanent members of your team in the form of management. The first step should be to start breaking down responsibilities by function and filling in the most critical role. Usually those are sales, finance, and operations. Luckily, today, there are more “fractionalized” C-suite personnel than ever before such as fractional VP of Sales, CFOs, and COOs. Fractional professionals offer important services on a part-time or fractionalized basis. For example, maybe you don’t want (or think you can’t afford) a full-time CFO but would like to have some sage financial advice one day a week (or maybe only once a month), a fractional CFO can provide those services. Don’t forget about human resources and IT, either!
Correcting the customer concentration issue may take time and some strategic thinking to solve. In particular, diversification can be done not only by number of customers but also by revenue stream. A high priority will have to be assigned to filling your pipeline with new opportunities so thought will have to be given on how to reach new prospects and then moving those opportunities down the sales funnel. This will likely require help from a sales professional (either a coach, VP of sales, or a general manager with strong sales experience).
Making changes requires investment in both time and money While there may be some initial pain involved in implementing your plan, the returns on investment can be immense if you.