Business A has ten clients and doesn’t feel it needs to market itself strongly. It produces steady revenue and is valued at $1 million. Business B has 200 clients, work frantically year-round, produces a high number of transactions, but only gets a valuation of $500,000. All things being equal in operation cost and infrastructure, what gives? The type of clients a business obtains is the difference.
For service-oriented businesses in particular, the quality of earnings is impacted most heavily by the quality of its customers. A valuation assessment will look at the risk factors associated with the continuing patronage of the firm’s customers. Common questions come up such as:
- Are they credit worthy?
- Do they remit payment within terms?
- Is there reasonable retention of customers relative to industry standards?
- Are they a diverse array of organizations or are they a narrow type of customer?
These are all key factors in assessing risk.
For many firms, the biggest risk component of their current business model is a concentrated clientele. Similar to diversification of stocks, the ideal client portfolio is spread across multiple industries so that a downturn in one does not bring down the whole group, thus killing all your revenue at the same time. Non-diversification is where all your clients come from one specific vein or slice of an industry. The assessment of your portfolio concentration always takes into account the specific organization and industry of the entity being valued. It can be universally applied that the more diverse and voluminous the clientele, the less the risk; the loss of no one client would be material, no one client can dictate unreasonable terms and conditions, and the payments of no one client materially affect the financial condition of the company.
Of course, any smart business owner prides him or herself on bring business in. The idea of turning down business creates almost instant heartburn, especially when the deal is a big one. So, on the natural business operators are loathe to turn down business – especially from their largest ongoing client. The difficult balance is in expanding the enterprise with the broadest possible mix of clients/customers given the realities of the marketplace for that business/industry. There are many successful firms that grew by the benefits of a small cadre of clients; conversely there are many instances of growing firms destroyed by the loss of a key client. When assessing value, the determination of risk associated with a concentrated client-/customer-base takes into account the specific market realities.
Valuation theory is highly subjective, but with respect to client concentration, the actual risk associated with too few clients providing too much of the revenue mirrors closely the negative valuation impact of that concentrated clientele. Potential buyers would similarly assess the risk, and modify their value assessment accordingly. After all, the most important asset of an ongoing enterprise is the revenue stream.
There are no automatic formulas to apply globally to determine a potential value reduction; each client in a portfolio needs its own analysis. In strategic planning for your business, development of the client/customer base is clearly a crucial issue. If you are building your exit strategy, keep this in mind and take a close look at your client list as if you were a potential buyer. If you have a major client who represents a large percentage of your revenue, a focused effort now to expand your client base may make your firm more attractive to potential buyers in the future.
Neil Lemons is an independent writer who enjoys writing articles to be used as business valuation resources. He has years of knowledge, and has written many articles about business valuation, with a particular focus in the business litigation services arena.