If you take your company to market, there are clearly delineated phases to your engagement with a serious suitor. After you have whittled down your offers to the acquirer who seems right for you, and the acquirer can demonstrate that they can finance the deal, the acquirer you have selected will submit a Letter of Intent (LOI). You will both sign the LOI. That starts the due diligence process, which can go on for upwards of 12 to 14 weeks, or even longer.
During the due diligence process, one of the informational items that you will be required to surrender is your customer concentration. You will be asked to show at least your top-ten customers, by name, with their sales figures. Often, an acquirer will want a longer list, perhaps asking for your top-30 customers.
We’ve covered this customer concentration topic in another column, but as a rule of thumb, keep this figure in mind: No one customer should represent more than 10% of your business. The reason is obvious. An overly concentrated customer list at the top puts you at risk for lack of revenue diversification.
In addition to seeing your customer concentration, a shrewd acquirer will also ask to see the Gross Profit Margins (GPMs) for each of your top customers. The reason for this is simple: The acquirer wants to make sure you are not discounting these customers so heavily that you are not consistently profiting from your sales to them.
We all know the dynamic of discounting your largest-volume customers. They hammer you down on price, reasoning that you’ll make up the margin on the high volume of sales to them. Fair enough. No big buyer would be worth his salt if he didn’t ask for a volume discount. But it does cost you a fixed amount of money to service these accounts. And there are allocated costs to associate with every customer for personnel, marketing, and other Selling, General & Administrative Expenses (SGA) costs. So, as margins get smaller with high-volume customers, you eventually risk shorting yourself below your all-in costs with too much discounting. An acquirer will want to know that.
You may be surprised during the due diligence process to have an analyst come back and say the acquirer isn’t going to fully recognize the revenue from certain customers, because, in a fully weighted analysis, you are selling to them at or near a loss. That can drive down your valuation, sometimes dramatically.
What looks good to an acquirer? They would like to see that you maintained discipline by keeping GPMs for your top-volume customers at or near the GPMs for the customers further down the list of volume sales. Consistent GPMs across customer types shows you didn’t capitulate when negotiating prices, and it reflects well on your company.
Before you go to market, engage in the exercise of comparing GPMs for your largest and smallest customer and see where you stand. Do what you can to instill consistency before going to market.
On the subject of customer lists and the due diligence process, note another potential hazard. Once you share your top customer list with a potential acquirer, that acquirer will be extremely weary if you lose a big customer during the due diligence process. In fact, if you suffer customer attrition among your high-volume customers, the acquirer will very likely request repricing the deal. It’s only fair.
The purchase price the acquirer set forth in the LOI was based on that fact that you will hit your revenue projections, and if you lose a customer, and miss your numbers because of that loss, the acquirer will look at your company value differently. The tough part is that they get to renegotiate the purchase price. As I have pointed out in another column, this repricing never moves up in purchase price, should you exceed your numbers; it moves only down if you miss them.
Bottom line: Work with your broker to do a GPM analysis early-on, and be prepared to defend your numbers with a good explanation if your GPMs are ever challenged.