In past articles I wrote on how a business owner can be confident their business is valuable and sellable when the time comes to transfer ownership. I recommended what to look for in cash flow and how to retain key employees. Now customers will take the stage. Everybody knows customers are important, but what exactly makes them valuable to a buyer?
Customers are valuable because we expect them to buy again in the future. Two key factors point to the value of a customer base. First, how “sticky” are the customers? Second, what is the loss if a customer leaves?
A “sticky” customer is one that comes back. There are soft reasons why customers come back such “customer service” and “relationships”, but often relationships change in an ownership transfer. The only customers valuable to a buyer are the ones that are going to stay. A valuable tool for measuring customer “stickiness” is by measuring recurring revenue.
There are 4 tiers of revenue that we use.
(1) A One-time Customer is the least valuable customer because we do not expect them to come back. A good example is the owner of a custom home, who is unlikely to hire the builder again.
(2) A Repeat Customer is one that orders periodically. For example, a business might place an order with their print shop every 2-3 months. This customer is somewhat valuable, but there is little holding them to the company, especially of the people change in an ownership transition.
(3) A Recurring Customer is on a regular billing cycle and has inertia that keeps them coming back. An example would be a janitorial company that has ongoing commercial accounts.
(4) A Subscription or Contracted Customer is the most sticky and valuable form of customer. Typically it would be difficult and costly for them to switch to a different provider. An example would be a software subscription or a cell phone contract. It is key to consider if customers will remain sticky through an ownership transition. Make sure any contracts are assignable.
Recurring customers bring cash flow stability. Most businesses can develop a business model with recurring revenue for at least a portion of their sales. This could be as simple as introducing customer contracts in a service business. In product-based businesses a sticky customer might have a service agreement or buy a consumable item related to the product.
In cases where a product or service is one-time nature, such as a company providing fire and water restoration, there is still hope of significant value. Consistent future cash flow can still be achieved if the company has a sales system or distribution network that generates consistent new customers without owner involvement.
Even with sticky customers there is always a risk of losing customers. The second variable in the value of a customer base is customer concentration. How will the loss of a customer impact the business? I know a growing manufacturing company that has one customer holding 70% of their sales. They are operating with significant risk because there is no contract or other commitment in place.
To find customer concentration percentage, simply divide the sales from the largest customer into the total sales. Customer concentration over 10% represents a noticeable risk and concentration over 25% will materially reduce the business value. It is helpful to repeat the calculation with the top 3 customers and to consider how top customers influence profit margins.
Companies that have high customer concentration at the time of an ownership transfer will likely see a portion of the sale price being contingent on retainer certain customers.