How does revenue concentration impact a business sale?
Do you prefer securing fewer clients who each generate more revenue, or working with more clients but who in aggregate produce a similar level of revenue? If you are like many small business owners you may perceive this to be a no-brainer, understanding that the fewer clients you work with the less sales, general, and administrative expense you'll likely have - not to mention the hassle and headache of dealing with a broader number of clients.
However, when it comes to selling a business, having higher percentages of revenue coming from fewer clients may negatively impact marketability and value. Business buyers are interested in acquiring companies that have low risk to future cash flow. Generally when a business has more than 7% of its revenue coming from any single client, buyers will begin to be concerned about the financial risk of losing larger clients and this will start to impact price and deal structure.
Following are a few suggestions on ways to prevent this from becoming a marketability issue:
The easiest way to remedy this problem is the most obvious: gain greater client diversification before attempting a sale. For some businesses this may not be practical if a sale is desired within a couple of years.
Formalize your client relationships with long-term contracts. Client contracts that are for multiple years and/or that have longer notice requirements for termination will help to alleviate buyer perceptions of risk. Unfortunately, clients may be reluctant to enter into such contracts without easy ways to terminate the contracts.
Agree to an earn-out as part of the business sale deal structure, where part of the payment for the business is contingent on future retention of clients and/or maintaining a certain level of revenue or cash flow. In some cases a business seller may even do better financially with an earn-out. However, an earn-out may not be ideal for a variety of reasons including: A, the loss of key clients may result in a seller not receiving a portion of the anticipated value for their business; B, a portion of the payment for the business will be deferred - possibly for a few years; and C, if the business doesn’t perform well despite retention of key clients and through no fault of the seller, there’s the risk of non-payment even if the deferred consideration is earned.
Accept a lower price in order to compensate for the buyer risk of losing a key client.
Following are two videos that provide more information about earn-outs.