Customer Spread

A business can have clean books, documented add-backs and a year of strong earnings and still be priced well below what those earnings suggest. The reason is usually on the customer list. If one or two accounts carry the year, and especially if the owner won them personally and looks after them personally, a buyer has to ask what happens to those earnings when the owner leaves. Nobody can say, and buyers price that kind of uncertainty at its worst.

Customer Spread is the driver that answers the question with evidence. It moves SDE from earnings carried by a few relationships to earnings spread across a customer base, and it uses two years of monthly history to show that the latest year is not a spike.

A list with each customer's share

It begins with a customer list for the latest year, drawn from the sales ledger, showing every customer's revenue and share of the total.

That sounds like the most basic report a business could produce, and some small businesses still cannot produce it, because the invoicing was never organized by customer or because sales were made without recording who bought. The habit behind it was set up on the first span: every invoice names its customer, and every payment lands in the business account. From there the list is a quarterly report from the ledger, sorted by share, with the largest customers marked.

Without the list a buyer cannot judge how dependent the business is on its largest customers, and in that position a buyer assumes the dependence is high.

No customer large enough to take the business with them

Over the latest year, the largest customer should account for less than a large share of revenue, or else be under a written contract that is disclosed to the buyer.

Buyers at this anchor weigh this heavily. A buyer of an owner-run business is usually an owner-operator who will take over the seller's relationships, and what they fear most is that the biggest of those relationships belongs to the seller personally. If that customer leaves in the first year after the sale, the buyer has paid for earnings that walked out with the person who sold them.

The illustration puts numbers on that fear. A business with $1.2 million of revenue whose largest customer is 31 percent of it would lose $372,000 of revenue a year if that customer left, about $12,400 of gross profit every month. A reserve of $30,000 covers that for under two and a half months, which is not long to replace a customer that size. A buyer who runs the same arithmetic will lower the price, ask for part of it to depend on the customer staying, or walk away.

The risk can be brought down in two ways. One is to dilute it: set a quarterly target for new customers outside the top account, tracked in the pipeline built on the first span, so the largest customer's share falls as the rest of the business grows. The other is to secure it, by putting the largest accounts under written agreements with a term, a price and a notice period, signed in the company's name rather than the owner's. A contract cannot make the customer stay. What it does is turn an informal relationship into an obligation of the company, which a buyer can acquire, and give the buyer a notice period to respond in if the customer does decide to go.

How a buyer prices the risk

A buyer prices concentration in two places. The first is the valuation. The framework treats the loss of the largest customer as a named scenario: the probability that the customer leaves, times the gross profit the business would lose, valued like any other change in cash flow. Bringing the largest customer's share down shrinks the loss in that scenario, so it raises the value of the business itself, over and above whatever it does for the price.

In the illustration, the largest customer at 31 percent of revenue puts about $148,800 of gross profit a year at risk. If new customers elsewhere bring that share down to 20 percent of the same revenue, the gross profit at risk falls to $96,000. At an illustrative 25 percent chance of losing the customer in a year, the expected loss falls by $13,200 a year, $9,900 after tax, and capitalized at an illustrative 20 percent cost of capital that is about $49,500 of value. Total revenue never changed; only how it is spread across customers did.

The second place is the terms of the deal. A buyer who doubts the largest customer will stay often proposes to pay part of the price only if the customer does, through a holdback released after a year or an earn-out tied to the customer's revenue. The seller then carries the very risk they were trying to sell, and receives that part of the price late, if at all. A written contract with the customer, a smaller share of revenue, or both, give the seller grounds to resist those terms.

Two years that show the year is not a spike

The last piece is two years of monthly revenue history, built from bank deposits and matched to the tax returns, with the latest year not materially below the one before, or with any decline explained by a documented cause that will not recur.

A single strong year is ambiguous. It might be the start of a trend or the best year the business will ever have, and a buyer who sees only one year cannot tell which. Two years of monthly history show the shape: whether revenue is steady, growing, seasonal or falling, and whether the latest year is typical or exceptional. This is the same worry about whether the earnings will last, approached from the calendar instead of the customer list.

The history is assembled from the bank statements, taking deposits less anything that was not revenue, and matched to the returns for each year, because deposits are the one record the business did not produce itself. Any decline is documented when it happens, while the facts are fresh: the cause, the evidence and whether it will recur. A decline explained at the time by a lost contract the business has since replaced reads very differently from the same decline explained two years later by an owner trying to remember what happened.

What has to be in place first

The driver depends on two habits from the first span. Revenue has to have been invoiced and collected into the business account from the start, because the history is only provable if the deposits are. And there has to be a working sales pipeline, so new customers come from a process the business controls and not from the owner's own contacts. A business that won all its customers through the owner's network will struggle to bring its largest customer's share down until it has a way of winning customers that does not depend on the owner.

Knowing that it works

Concentration shows in the largest customer's share of revenue over the trailing year, reported each quarter. Whether the base is widening shows in the number of new customers each quarter from outside the top account, and whether the business is growing at all, in the trailing year's revenue against the year before, each month.

The check that can be put to the owner is the question a buyer will ask: what happens if the largest customer leaves tomorrow? The answer should come with numbers, meaning the revenue and gross profit that would go and how long the reserve would cover the gap. An owner who can give it has thought about the risk before the buyer raises it. One who cannot will be answering it for the first time in the meeting that sets the price.

Why it slips, and what holds it

The decay here is revenue coming to rest on one large customer, or on the owner's own relationships, all over again. Usually nobody chooses it. A good customer grows, and a business busy serving them has less time to win others; the owner's contacts are the easiest source of new sales, so more of the new business comes through the owner.

The safeguard is a concentration review every quarter, with a ceiling. When a customer approaches the ceiling, the review triggers one of the two responses, a written agreement with that customer or a push to win customers elsewhere. The point of the review is that the business notices concentration while it can still do something about it, well before a buyer's analysis of the customer list points it out.