Question:

I am thinking about buying a local transportation and storage company. They have been around for about eight years and specialize in commercial accounts. Only about 25% of the business is residential relocation. The business has grown every year and nets about $175,000 to the owner (including everything). They lease all of the vehicles. They are asking $525,000 for the business and will finance about 50% for a qualified buyer, which I am. The problem is that three of their accounts represent 65% of the business. Of this, almost all of this revenue is related to long-term storage and moving of their stored merchandise. How can I possibly protect myself and what should I be aware of in this situation?

Answer:

This is a GREAT question.

In many businesses, one does come across customer concentration issues.

However, one must consider the specific nature of the business itself to determine:

1. Is customer concentration the norm in this particular industry?
2. What is the impact on the business should the customer(s) stop buying?
3. How “easy” is it for the customer to go to a competitor? Why would they?
4. Is there a special relationship between the current owner and the customer that keeps the business safe?
5. What can be done in the future to lessen this percentage of concentration?

Let’s examine all of these points:

• In the commercial storage business, it is quite acceptable to have a higher than average degree of customer concentration. If you were selling a highly competitive product rather than a service, I may be inclined to be concerned, but not necessarily in this case.
• Clearly, you’ll want to determine the impact should one of these key customers stop buying from you. To this end, you should do a Pro Forma budget isolating each one of these accounts both from a revenue and net income perspective to understand your exposure.
• In the commercial storage business, you will be providing the pain relief to your customers. The service you provide eliminates a headache for them. If the business is like most commercial storage businesses, where you charge every time you handle the goods for them, it is not really easy per se for them to go to a competitor, nor do they usually want to. All these clients want is for you to do what needs to be done, when they need it done. This means picking up on time, and delivering on time. This is very much a business that is yours to lose. So, do your job well and you won’t give them a reason to even consider switching!
• You will certainly want to review any contracts in place to understand what is involved in the event of a change in ownership. They may simply be able to roll these over to you. Or, they may require written permission. Some can even have far stricter language that doesn’t allow these to be assigned. In any event, you need to know the details and also what is the relationship between the sellers and the clients that keeps the business secure.
• I would absolutely recommend that you look to increase the client base. This may be time-consuming because just like these customers won’t be quick to place their goods elsewhere if you do your job, neither will other prospects be quick to give you their business. It takes time to secure new business in the industry. So the lesson here is to take very good care of what you’ve got because it won’t come back easily if you lose it.

As far as protecting yourself, the most effective strategy for any business with customer concentration issues is to establish part of the purchase price as an earn out or performance based purchase.

You should also keep in mind that the seller cannot guarantee the revenue to you for perpetuity. If the new owner messes up the business, it is not the seller’s fault. However, they should be able and willing to effectively guarantee the business for at least 6 – 12 months. You will need to determine the percentage of revenue/profit each major client represents and then factor this by the multiple being paid for the total business, and then this amount should be evaluated and paid at a future date.

As an example, if you are paying $525,000 for the business on $175,000 owner benefits then this is a three times multiple. If the key accounts represent around $113,000 of the $175,000 this would equate to $400,000 of the purchase price. In 6-12 months you revisit the numbers and if the revenue/profits are still in place, then the seller earns this $400,000 and, ideally, you should build it into the note. If business declines, the $400,000 is adjusted accordingly. In this business, I would suggest a 12 month period since the customer turnover rate is quite low and the clients may take a little longer to evaluate you as well.