Reducing Concentrations of Risk Before Selling Your Business

Executive Summary

Concentrations of risk can have a significantly negative effect on the value of your business. The value of a business, or any financial asset, is a function of the relationship between potential return and risk. The higher the risk, the lower the value. The higher the return, the higher the value. One foolproof method for increasing the value of your business is, therefore, decreasing concentrations of risk.

Concentrations of risk occur primarily in the following four areas:

• Customer concentration
• Staff concentration
• Product concentration
• Distribution channel concentration

Here’s what I mean:

In one recent transaction we were working on in the tech space, a deal ultimately unwound because the customer concentration was too high, and the buyer could not obtain a sufficient amount of comfort that a key customer would be retained.

Another transaction involving a $5 million landscaping company derailed because of a high concentration of responsibilities and authority in key employees. After one key employee threatened to leave, the entire transaction was off and we could not revive the deal.

 In a different transaction for a commercial cleaning company, the buyer was a savvy direct competitor and proposed several strict deal-protective measures designed to insulate the buyer from high customer-concentration risks. Later in the transaction, the competitor also attempted to renegotiate the purchase price and proposed a lengthy holdback period (a.k.a. escrow). We were ultimately able to complete the transaction, although the seller received significantly less than they would have if customer concentration had not been an issue.

The impact of concentrations of risk varies based on a specific buyer’s appetite for risk and their perception of the risks present in your business. Every buyer will respond differently when presented with risk. Some buyers will back out entirely and pursue a less risky venture. Others may agree to move forward, but only if protective measures can be instituted to lessen their risk or if the purchase price can be reduced to offset the increased perception of risk.

Concentrations of risk can:

• Deter buyers from making an offer on your business.
• Reduce the value of your business.
• Reduce the chances of selling your business.
• Increase the thoroughness of the buyer’s due diligence.
• Reduce the amount of cash down you receive at closing.
• Increase the amount of escrows or holdbacks.
• Increase the strength of representations and warranties in the purchase agreement.

In most cases, concentrations of risk cannot be quickly remedied. However, they can often be mitigated in the short term or significantly reduced in the long term. Addressing these concerns often takes a significant amount of time and energy, but reducing the concentrations of risk can dramatically increase the value of your business and improve the chances of a successful closing. This can also improve the chances of a successful sale, minimize the amount of holdbacks, and reduce the strength of reps and warranties in the purchase agreement.

This article explores the four major concentrations of risk in most businesses and offers specific advice for minimizing the impact of each concentration of risk. Following the suggestions outlined here will not only improve the chances of successfully selling your business but will also improve its value.

Risk #1: Customer Concentration

Customer concentration occurs when a small number of customers generate a significant percentage of your business’s revenues. Following are examples of how the amount of customer concentration is often expressed:

• The top customer generates 57% of the business’s total revenue.
• The top 3 customers generate 27% of the business’s total revenue.
• The top 5 customers generate 42% of the business’s total revenue.
• The top 10 customers generate 3% of the business’s total revenue.

The higher the customer concentration in your business, the more risk this presents to the buyer. On the other hand, the greater your customer diversity, the less risk a buyer will view in your business. In extreme circumstances, we have encountered businesses that could not be sold due to high levels of customer concentration.

How much customer concentration will buyers tolerate?

Some buyers will tolerate customer concentration as high as 20% to 30% — for example, if one customer generates 20% to 30% of your revenue — but buyers will expect numerous deal-protective measures (escrows, earnouts, etc.) or a reduction in the purchase price to offset the increased risk. If you have customer concentration above 30% to 50%, then your business may be unsalable unless you are willing to agree to a deal structure that offers the buyer numerous protections if one of your customers leaves shortly after the closing.

While the exact figure depends on the industry, customer concentration generally becomes a problem once a customer generates more than 5% to 10% of your revenue. If the concentration level is below 5%, many buyers won’t question the relationships at all. If it’s between 5% to 10%, then many buyers will begin to probe deeper and may start to consider measures designed to reduce the risk from customer concentration. If one customer generates more than 10% of your revenue, then expect to include protective measures in the purchase agreement or be prepared to reduce the purchase price to offset this increased risk.

Methods for Reducing Customer Concentration Risk

There are two methods for addressing customer concentration risk:

1. REDUCE Customer Concentration: This method only works in the long term and involves diversifying your customer base so that no single customer generates more than 5% to 10% of your revenue. If you are selling your business in the next year or two, this likely won’t be practical. For example, if one customer generates 50% of your revenue, focus on obtaining new customers (i.e., diversifying your customer base) and reduce your dependency on that one customer. This obviously is not possible in most cases in the short term, but many businesses can diversify their customer base over time.
2. MITIGATE the Risks of Customer Concentration: This method involves instituting measures designed to reduce the risk of customer concentration to the buyer without actually reducing customer concentration and includes the following:
   • Long-Term Contracts: Ask your key customers to sign long-term contracts. Offer incentives in exchange for signing a long-term contract, such as grandfathered pricing or other sweeteners, such as free support, discounts, or other add-ons.
   • Institutionalization: Institutionalize your relationships with your customers. In other words, reduce the level of your personal involvement with the customers. If you have a strong personal relationship with a customer, slowly transition the relationship to some of your key employees who will remain with the business after the closing. But before doing so, make sure you have also implemented a retention plan with your key employees (see Risk #2: Staff Concentration) to ensure the customer relationship transitions smoothly to a buyer. If there is a risk that your key employees won’t stay after the closing, then such a strategy won’t reduce the risk for the buyer.
   • Deal Protective Measures: Deal protective measures include escrows, earnouts, holdbacks, and other forms of contingent payments. You can’t take action on these items prior to a sale, but you can be mentally prepared to accept such protective measures, or you can include specific proposals in your offering memorandum designed to reduce the risk. By proposing specific mechanisms for reducing risk, the buyer will feel that you understand the risk inherent in customer concentration, and they will feel comfortable that you are prepared to address this risk. In most cases, an escrow, or holdback, is more appropriate for addressing customer concentration risks than an earnout and involves a portion of the purchase price being held in escrow by a third party. The amount held in escrow would then be released over time according to a schedule, assuming the customer is retained.

Risk #2: Staff Concentration

Aside from customer concentration, concentration in key employees is perhaps the most common area of concern for buyers and is one of the most prevalent areas of risk present in small to mid-sized businesses. The smaller the business, the more likely this will be a concern.

How much staff concentration will buyers tolerate?

The degree to which this is a concern depends on the three types of buyers described below and can be broken down as follows:

Buyer Type #1: Private, Wealthy Individuals: Individuals are less likely to consider staff concentration an issue if they plan on being involved in the day-to-day management of the business and can step into your shoes and continue operating the business as you did. However, this assumes that all employees stay with the business after the closing — with the exception of you, the owner. If the buyer assumes your duties and your key staff are willing to stay post-closing, then a concentration on employees is unlikely to be considered a deal killer by most individual buyers.

If, on the other hand, you and your spouse work full-time in the business, and you have a few family members involved who will not be staying with the business post-closing, then this will be a concern for the majority of buyers. The primary exception to this will be direct competitors who have the capacity to bring their own team to the table or husband and wife teams with strong industry experience who will both be actively involved in the business.

Buyer Type #2: Financial Buyers: Most financial buyers only buy businesses that have a team in place that can manage the business post-closing. If the business is heavily dependent on you, and you are not willing to remain with the business after the sale, then it’s unlikely you will be able to sell your business to a financial buyer. The primary exception will be financial buyers who are planning to hire a CEO to replace you or buyers who own a portfolio company in your industry and plan to integrate your company into their platform company. In these cases, they are not dependent on your key employees.

Buyer Type #3: Strategic Buyers & Direct Competitors: Selling to a strategic buyer or competitor is the simplest method for reducing the risk associated with staff concentration. However, the degree to which this risk is mitigated depends on the extent to which the buyer will integrate your business and your products into their business. If the buyer plans to operate your business as a stand-alone business post-closing, then a management team will need to be in place to run your business for the buyer after the closing. On the other hand, if the buyer plans to fold your product or services into their existing product suite, close your facility, or eliminate duplicate functions such as accounting, HR, legal, etc., then a concentration in responsibilities is unlikely to be considered an issue.

Methods for Reducing Staff Concentration Risk

Reducing concentrations of risk in your staff requires: 1) developing excellent management skills and 2) building infrastructure, and can be broken down into the following strategies:

• Distribute Responsibilities: Evenly distribute responsibilities amongst your team so the business is not dependent on you or any individual — avoid high concentrations of responsibilities in any one individual.
• Distribute Authority: Evenly distribute decision-making authority within your firm. Make sure authority is not highly concentrated on one person.
• Build a Strong Management Team: Build a management team capable of developing and executing their own strategy and goals and that has the authority to make their own decisions. Only hire experienced people with a demonstrated history of achieving results.
• Only Hire Highly Capable People: Only hire talented people capable of operating on an autonomous basis who do not depend on input from their senior managers to plan and execute objectives.
• Implement a Retention Plan: Develop and implement a retention plan to retain your key employees after the closing. The retention plan can consist of a cash bonus or equity incentives, such as phantom equity.
• Sign Agreements with Key People: Ensure you have signed employment contracts with your key people to cover the issues of confidentiality, non-compete, and non-solicitation.
• Eliminate Personal Relationships: Reduce or eliminate any personal relationships you have with customers and delegate relationship-building evenly across your staff.
• Build Trust Through Timely Disclosure: Reassure your team that the transition provides an opportunity for them due to a potential increase in benefits or salary. Reinforce the role and value of the retention bonus.

Realistically speaking, we recognize the difficulty of implementing our advice — every entrepreneur understands the value of building a management team. The issue isn’t understanding its importance — the issue is actually building a strong team, and this is certainly easier said than done. We realize this is a Herculean task. However, as an entrepreneur, you must understand that the more indispensable you are to your business, the more difficult your business will be to sell — and the less your business is worth. We have never claimed that being an entrepreneur is easy, and learning to become a successful manager is not an easy task either.

If you just received a $20 million venture capital injection, then you can afford the best talent available and motivate your team with stock options and other incentives. Such scenarios tend to attract strong, autonomous, driven talent. But, if you own a small software company in Boise, Idaho, that generates $2 million in revenue, and you have no institutional investors backing you, then you must learn to make do with less.

We understand the limitations inherent in a small business and empathize to a great degree with entrepreneurs struggling to make the leap from a small to a middle-market business. Many business owners are looking to sell because they can’t make that leap from a small company highly dependent on themselves to a middle-market business run by an independent management team.

Other than retirement, this is perhaps the number one reason entrepreneurs sell their business — because their business is highly dependent on them, and they feel as if they “can’t escape their own business.” They have no time to relax, can’t take vacations, and have a hard time letting go. It’s a catch 22 — they want to sell because the business is so dependent on them — but they wouldn’t sell if the business weren’t dependent on them. What’s the solution? Either way, the solution is to try to reduce your business’s dependency on you.

Nonetheless, it’s important to understand the circumstances in which a strong team is necessary and under what circumstances you can sell your business despite high concentrations of risk in your team. It’s also important to prioritize the actions you can take and the degree to which buyers see value in those actions. Understanding the high-level picture will help you prioritize your actions and determine to what degree you should attempt to reduce the risk and whether expanding this effort is worth the lost opportunity cost to you.

Assessing the potential impact of staff concentration is nuanced and dependent on more variables than assessing the impact of customer concentration. Every situation is different, and it is best to obtain the advice of an experienced M&A professional to evaluate your specific business. They can help determine the probability of selling your business without building a strong management team and help you prioritize actions you can take to reduce risks in employee concentration in the interim. At Morgan & Westfield, we bring our decades of experience to each conversation with every client. During our initial assessment of a business, we carefully evaluate the business to determine its primary value drivers and potential deal killers. We then outline a specific game plan for each owner that includes a prioritized list of actions they can take to improve the chances of successfully selling the business. We suggest developing a similar plan for your business.

Many excellent books have been written that can help you transform your company into an established middle-market company, and we recommend the following:

• Scaling Up — by Verne Harnish
• The New One Minute Manager — by Ken Blanchard and Spencer Johnson
• Ready, Fire, Aim — by Michael Masterson
• The Breakthrough Company — by Keith R. McFarland
• Business Model Generation — by Alexander Osterwalder and Yves Pigneur
• The Founder’s Dilemmas — by Noam Wasserman
• Who: The A-Method for Hiring — by Geoff Smart and Randy Street
• Ownership Thinking — by Brad Hams
• Scrum: The Art of Doing Twice the Work in Half the Time — by Jeffrey Victor Sutherland
• Work Rules! — by Laszlo Bock
• Organizational Physics — by Lex Sisney
• High Output Management — by Andrew S. Grove
• Measure What Matters — by John Doerr

Risk #3: Product Concentration

Product concentration is the degree to which your business is dependent on a specific product or service.

For example, if you own a manufacturing firm and 90% of your revenue is generated from manufacturing one product, your business is considered to have a high product concentration.

How much product concentration will buyers tolerate?

Generally speaking, buyers are much less concerned with product concentration than with customer or staff concentration. We sell many businesses with product concentration in excess of 80%, and high product concentration is not a major concern for most buyers. However, in some cases, product concentration can be a deal killer. For example, if you have an online business, and 50% of your revenue is generated from the sale of one product that is considered to have a short life span, then it’s possible a buyer may consider this a deal killer.

Product concentration is not absolute.

The risk of product concentration is not absolute, like staff concentration, and can’t be objectively measured or predicted. It is nuanced and dependent on many variables and subject to a variety of perspectives — depending on who the buyer is, such as an individual, a financial buyer, or a strategic buyer, and their purposes for the acquisition.

Whereas customer concentration can be boiled down to a certain number (e.g., customer concentration greater than 20% is considered a risk), product concentration can’t. Instead, the risk associated with product concentration is assessed based on the underlying risks of your product. What is the typical lifespan of a product in your category? How susceptible is your product or service to obsolescence or new, innovative solutions? The risk of product concentration is considered on a collective basis and can’t be boiled down to a specific number.

Product concentration is considered a risk in industries that have a high degree of innovation and new product development or if your product is susceptible to technological obsolescence — in other words, if a new product is likely to outseat your existing product.

We sell many businesses in which 100% of the revenue is generated from one product or one service. In most cases, this isn’t considered an issue by the buyer. On the other hand, we have encountered online businesses with one product that generated over 50% of their revenue and that one product was marketed solely through one channel (e.g., Amazon). In this case, high product concentration made the business unsaleable. It’s the big picture that buyers consider, not risks in isolation.

Reducing Product Concentration Risk

Risk can be mitigated if the buyer of your business plans on integrating your product into a wider suite of their existing products. In software companies, buyers often add your software to their existing product line and distribution network, which can result in dramatically increased revenues. This enhances their existing customer relationships since they can offer a wider suite of available services and simplify operations for the end-user as they have fewer relationships to maintain. This can also serve as a vehicle to establish new relationships by opening doors to new customers who have a need for your new product. Collectively, a situation like this changes the buyer’s perspective from one of mitigating risk to one of capitalizing on opportunity. By focusing on opportunity, you take the buyer’s focus off risk.

Regardless, every business is unique. If you are unsure, an experienced investment banker or M&A advisor can often determine if product concentration is an issue in your business. This is one of the many factors we consider during our assessment and preliminary valuation of a business.

Risk #4: Distribution Channel Concentration

Distribution channel concentration is the degree to which your business is dependent on a specific distribution channel.

For example, if you have a tech or online business, and 90% of your revenue is generated from Facebook Ads, then your business is considered to have high distribution channel concentration.

How much distribution channel concentration will buyers tolerate?

Buyers are concerned with distribution channel concentration to the degree to which that distribution channel is considered stable.

For example, we recently advised one client who had an eight-figure business that was dependent on one distribution channel — Amazon. If Amazon made just one minor change to their business model, they could be out of business overnight. Because Amazon is still quickly growing and innovating, and its policies continue to evolve, this is considered a riskier distribution channel than organic search methods such as Google.

Ideally, your sales and marketing methods should be diverse, and your business should not be dependent on any single channel. If you own the channel, all the better.

About ten years ago, I encountered a business owner whose business was shut down overnight because of an issue he had with PayPal and eBay. His business went from generating seven figures to grinding to a halt in less than 24 hours. I got in my car to meet him to see if I could help because I felt so sorry for him.

When I arrived, his office looked more like a living room than an office — I later found out that was because it was his living room. His situation was so destitute he had lost his home and was living in his office. When I arrived, a middle-aged man with a salt-and -pepper beard wearing blue sweatpants and a grey hoodie stumbled around the corner. The floor was littered with microwave dinner packages, old bags of Doritos, and empty Coca-Cola bottles. He shuffled towards me, carrying a piping-hot bowl of soup. I tip-toed over the empty packages and grabbed a seat on a beat-up recliner while he explained his situation as I listened with disbelief.

His situation was so sad that I remember shedding a tear or two (ok, ok, maybe three tears). He told me he lost everything overnight. All because he was dependent on eBay and PayPal. Due to a dispute, they shut his account down overnight. He had to lay all his employees off. His fate was entirely in the hands of a monolithic bureaucracy that couldn’t care less that he was now homeless and destitute. His disputes fell on deaf ears, and his situation remained bleak. Unfortunately, there was nothing I could do to help other than offering comforting words of encouragement.

These stories are far from rare. Rags to riches, and then back again, is not uncommon. I have encountered other business owners who lost everything — in some cases, wealth that took decades to build instantly vaporized.

Reducing Distribution Channel Risk

The best antidote to these risks is to eliminate any dependencies your business has on third parties. If you are dependent on Amazon, Facebook Ads, Google Maps, Yelp, or other marketing channels, strategize to see what you can do to eliminate these dependencies. A change in the ranking algorithm of these channels can have a disastrous effect on your business overnight. As an alternative, in some cases, it may be possible to sell your company to a buyer who already has a diversified array of distribution channels. If they purchase your company, your business would then have access to these distribution channels after the closing, and the risk would be mitigated as a result.

The Founder’s Role

To further exacerbate this risk, founders are often the technical expert, or inventor, and lack sales, marketing, or business development backgrounds. If so, you should work to develop exposure and credibility in your industry — become a cited and published expert in your industry, so a favorable light is cast on your company. Build social media traction and industry institutional thought leadership. Develop a wide variety of proven advertising tactics and materials to eliminate dependencies on marketing channels.

Sales Team Concentration

In addition to marketing channel diversity, you should also build diversity across your sales team. Do you have one salesperson on your team who generates a significant percentage of your revenue? If so, it’s possible this individual may intentionally jeopardize the sale and blackmail you for a large payday in exchange for them assisting with the transition. Think this is unrealistic? I have personally witnessed this more times than I can count on my two hands. Work to build a diverse sales team and implement retention bonuses with your key salespeople to ensure they remain with the business.

Conclusion

Concentrations of risk can have a significant effect on the value of your business. While addressing concentrations of risk can take time, it can dramatically increase the value of your business and improve the chances of a successful closing.

Addressing Concentrations of Risk is More Art Than Science

While assessing the potential impact of customer concentration risk is straightforward, assessing the risk of staff, product, and distribution channel risks is more nuanced. If you would like to maximize the value of your business, and if you have a concentration of risk in staff, products or distribution channels, we recommend you obtain the advice of an experienced M&A professional to assess your business and help you strategize options for mitigating these risks.

Develop a Strategy for Reducing Risks

In some cases, these risks can be addressed by targeting specific types of buyers (individual, financial, strategic) or by implementing deal-protection mechanisms. Sometimes these risks must be addressed up-front before your company is put on the market. Regardless, it pays to understand the potential impact these risks can have on your business and to what degree it is necessary to address these risks before you begin the sale process.