Many privately owned electronic businesses operating in the lower middle market can exhibit concentration in either the selling channel, the supply channel, or both. When the time comes to sell the business, what historically has been viewed as an area of strength by business owners can instead be considered a risk for potential buyers. Concentration can lead to lower valuations, more comprehensive due diligence, and additional deal terms and conditions.
Selling Channel Concentration:
Customer concentration is generally defined as how total revenue is distributed among the customer base. A company with a large number of similar-size customers has a lower concentration than a firm where a handful of large customers account for the majority of the business.
- Measurement: There is no formal definition of customer concentration. Instead, there is some industry consensus that if a single customer accounts for more than 10%-15% of revenue or your five largest customers account for 25%-35% or more of revenue; there is customer concentration. Business sellers should expect buyers to request three years of sales history. Buyers will then calculate concentration in each year and also in total. Note that buyers may have a mild concern at 10-15% concentration and will probe carefully, but when a single customer reaches 35% or more, some buyers will see the risk as too high and drop out.
- End customer/market concentration: In addition to calculating customer concentration as outlined above, buyers will also want to identify the true end customer/market for each of the company’s top customers. For example, if the sales from the top 3 customers represent 5%, 4%, and 3% of revenue but all sell into the same end customer market, the true concentration is 12%.
- Why is selling channel concentration risky for buyers: When a few customers represent a significant percentage of revenue, buyers are concerned about short-term and long-term revenue volatility. When concentration is present, a short-term revenue disruption can easily occur if a key customer experiences softness or a downturn in their end market. Long-term permanent disruption can occur if a key customer uses the change in ownership as an opportunity to pursue alternative lower-priced sources or if the key customer is acquired by a large company who then decides to move or resource the manufacturing to their strategic suppliers. In these instances, buyers worry if the company can generate new customers, how long will it take to replace the lost revenue, and if the company can meet all of its obligations in the interim.
- Examples:
- Electronic component distributor with direct and online sales: A concentration analysis revealed that one customer represented 10% of revenue, the top 5 represented 27%, and the top 50 represented 53%. During due diligence, the buyer probed further. A detailed analysis outlined that the company had a demonstrated track record of increasing recurring revenue and a detailed program in place to generate new customers. The buyer was satisfied, and the transaction closed.
- Electronic Manufacturing Services Business (EMS): A multi-year concentration analysis revealed that the top two customers represented 36% of revenue two years ago. One year later, sales to those companies represented 3% of revenue, and total revenue had declined. During due diligence the seller revealed that both companies were acquired and then directed by the new owner to place the business with their preferred sources. In addition, the seller indicated that apart from these two customers, revenue and profit had grown substantially. As a result, the buyer committed to adding sales resources was otherwise satisfied, and the transaction closed.
- Electronic Engineering Services Company: A DoD contractor did business with three customers and reported 95% of revenue from its top customer. During due diligence, the buyer learned the third in a series of 5-year Long Term Agreements was recently signed. In addition, the buyer’s attorney carefully reviewed the LTA and confirmed that a stock purchase would negate the need for novation (customer notification and approval). The buyer subsequently required the owners to agree to stay on for three years, although in a limited capacity. The buyer was willing to accept the mitigated risk, and the transaction closed.
Supply Channel Concentration:
When an organization is too reliant on one vendor or manufacturer to ensure an adequate product supply, it creates concentration risk. In other words, it increases the likelihood that a single point of failure can have a significant impact on sales, the supply chain, or the business’s financial health. There is no formal or informal agreement to calculate supply channel concentration within the financial services industry. Nevertheless, the overarching principle that “too many eggs in one basket spells risk” still applies. Each company should be carefully and individually scrutinized to identify areas of potential supply concentration.
- Original Equipment Manufacturers (OEM’s): Large OEM’s typically have formal processes in place regarding multiple sourcing, supplier qualification, and supplier splits. However, in today’s world of highly integrated and specialized electronic components, it is simply not possible to design electronic equipment without using specific sole source devices. Large companies will require that engineering justify the use of sole-source products and mandate that specific steps be taken to mitigate the potential concentration risk associated with sole-source items.
Often, small privately-owned companies do not adhere to these principles and may easily create risk by not doing so.
For example, assume an electronic equipment manufacturer is launching a new product and engineering decides to use an obscure sole source microcontroller manufactured by a company with less than 1% market share in microcontrollers as a critical element in a new product. Management will review this situation and advise engineering to select a microcontroller from one of the market leaders manufacturing microcontrollers. Although the new selection will also be sole-source it is more likely to be supported by the market-leading manufacturer and offer the company more assured supply.
As a second example, let’s assume an OEM outsources Printed Circuit Board Assembly to one supplier and that supplier chooses to do the manufacturing in a single offshore location. A lower-risk solution would formally qualifying 2 suppliers and split the business 60/40 with one supplier manufacturing onshore and one offshore. In addition, both suppliers would be repeatedly assessed for qualification, including capacity, credit, defects, component sources, etc.
Finally, let’s assume an OEM has two vendors qualified for a particular commodity and splits the business 60/40 based on performance/price. Let’s also assume that both vendors rely on the same third-party manufacturer for critical raw materials. Such a situation can easily create 3rd party concentration risk.
Sellers should expect the buyer to request vendor sales reports by commodity. Buyers will want to first work with the seller to identify critical commodities and discuss potential areas of risk associated with the vendors supporting those commodities. The bottom line, buyers will want to review any and all efforts in place to mitigate the identified risk.
- Distributors: Distributors’ supply concentration can create more risk than customer concentration as distributors support multiple customers from a single supplier. Buyers will want sellers to create 3 or more years of supplier sales data and calculate concentration as described in customer concentration above. Once concentration is identified, buyers will proceed as follows:
Inspect authorization agreements: Buyers will review all authorization agreements and give special attention to those representing the majority of revenue. Buyers will inspect the term and termination clause as well as the assignment clause. Assignment clauses typically refer to both notification and approval regarding a change in ownership. In an asset sale, all such authorization agreements will require novation in accordance with the language included within the assignment clause. All such agreements should transfer to the new owner in a stock sale without novation. However, best practices recommend outside legal counsel should review all agreements to identify any language that may negate and supersede the effect of a stock purchase.
Inspect the relationship with the supplier: Buyers will want to understand who within the seller’s organization has the key relationship with each supplier and who is the key person at the supplier that manages the relationship with the distributor. Buyers will insist on candid feedback regarding the status and health of these relationships.
Inspect both the supplier’s performance as well as the distributor’s performance: Buyers will want to understand the supplier’s overall market position within their commodity and ask the following fundamental questions. Are they growing and bringing new products to the market? Is the distributor increasing customer engagements and growing resales?
Buyers and sellers should be aware that manufacturers typically exercise significant control of their authorized resellers. In cases where there is a relationship or performance issue, manufacturers will want to use the change in ownership as an opportunity to make changes. Therefore, sellers are advised to review and assess relationship/performance from the manufacturer’s perspective before bringing their business to market.
Impact on valuations and solutions for mitigation: Once a buyer signs the LOI, initiates due diligence, and discovers concentration risk, the buyer is likely to consider one or more of the following mitigations:
- Extend the due diligence to investigate the areas of risk more closely
- Review assignment clauses in key customer/supplier agreements
- Conduct confidential 3rd part interviews with key customers/suppliers
- Lower the Purchase Price
- Revise the payment plan to include a multi-year earnout focused on revenue/customer retention.
- Extend the owner transition period. Note that this could be a limited role solely related to customer retention.
How can sellers prepare: A recommended best practice to ensure maximum valuation for your business is to engage the services of an M&A professional to complete a range of valuation for your company and, in doing so, identify areas of both selling and supply channel concentration before bringing your business to market. In addition, sellers should consider the following to mitigate risk for potential buyers:
- Engage key staff in transitioning leadership of customer relationships
- Develop and implement a strategy to create and grow a broader base of customers
- Negotiate Long Term Supply Agreements with critical vendors/customers
- Develop and implement a sourcing strategy to identify critical components and implement strategic sourcing for those commodities.
Summary:
Customer and supplier concentration can negatively affect business value, but as noted above, there are actions a business owner can and should take to prepare prior to attempting to sell their company. Beyond the scope of this article, in those cases where nothing can be done to mitigate concentration risk, the discussion moves more to finding buyers who can overlook the concentration and/or negotiating deal terms that work for both buyer and seller.
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