EP31 - The Good, The Bad, and The Ugly - Customer Concentration Issues for ESOPs

Welcome to the ESOP Guy. We are on a journey to an ESOP and so glad you are tuning in today. If this is your very first time tuning into this podcast, I just want to describe it is a resource that we created and produced to really help the listener who's thinking about using an ESOP and employee stock ownership plan in their business strategy if they haven't. Um, transacted before what this podcast does is it really provides information and insight into the steps on the journey on the journey to an ESOP that might be really relevant to what you're trying to accomplish. If you have an interest in other episodes, go to our website at journey to an ESOP.com. With that, I wanted to kick off this episode with this. Um, really quick here. If you don't recognize that, then you haven't seen this very famous movie. This comes from the famous movie called The Good, the Bad and the Ugly, which is our topic today. So we're going to talk about the good, the bad and the ugly related to a very common business risk, which is customer concentration. And as this risk is a risk to your business, it's the risk of potentially having a customer uh leave or lose that revenue and have it done, have it abruptly in your business where something happens and it could be really a difficult process to get through. For those considering an ESOP, this could be a very difficult problem or a major issue because it definitely will impair valuation depending on the degree of the customer concentration and it could really yield unfavorable deal structure in the process of doing your ESOP transaction. So with that, if you like what you hear on this episode or any other episodes, please subscribe to the podcast. And also rate the podcast, it's very helpful for us to get some feedback on the rating process. And if you know somebody that's thinking about going towards an ESOP and you think this might be a really helpful resource for them, please just share it with a friend and you can just hit that share button and, and send it to or text it to anybody you think might be, might be um a good listener or, or really appreciate um this podcast. So, with that, I wanted to start off this episode with just, just kind of an overview of the issue related to concentration risk. And I, and I'm gonna start that with just the idea behind the, the movie itself. So to me, OK, one of my favorite movies, The Good, Bad and the Ugly, it is a great story of really three bad guys. Um, one becomes kind of a good guy through the process of the movie or through the steps of the movie. Um, but they're bad guys because they're all doing something against the law. Um, the movie was, although a great American western or one of our greatest American westerns of all time, was actually filmed in Spain. And this would really be kind of the beginning of one of the greatest movie actor careers of all time, but Clint Eastwood, who stars in this movie. And I think makes probably one of the greatest um cowboys of the movie theaters of all time too. But anyway, you, we can argue that the plot of this movie is all about risk and reward. And so you start thinking about the way that these guys are going about their life. Everything comes down to a risk and reward and it really starts with in the beginning, the good guy, who is called Blondie. Has the ugly guy to go. Um, because Blondie is a bounty hunter and Blondie, um, kind of captures him and is gonna take him in and get the bounty on him, but, but he'll make more money at is, is turning him in, getting the bounty money, and then having Tuco, who is arrested and charged with these crimes, be hanged. And then right before he actually gets hanged, he's, he's shot down, the rope is shot by Blondie and then he falls on the horse and they, they, they gallop off to another town. And they keep doing the same thing over and over again to maximize the benefit of the bounty money that that Tuco has. Anyway, so, so it's really kind of this idea of risk and reward between, um, obviously if he misses that shot, then it's like a sudden end to Tuco and, and the whole thing kind of, um, it isn't, you know, it's, there's a nice reward at the end, but there's a lot of risk related to it. So then the bad guy comes in and the bad guy is called Angel Eyes and Angel Eyes um finds out about this treasure which is just stolen money. And so this, this whole theme of risk and reward kind of carries on and And part of the movie is, you know, Tuco and Blondie are, are kind of partnered up and then angelizes against them, but ultimately, they're all looking to, to get this, this reward at the end of the day. And they're willing to risk their lives. And at the very end of the movie, you know, it comes down to a gunfight, and I won't tell you the end, but the bottom line is, is all of their, um, reward was kind of in this one grave, and this one grave site in this graveyard and, and their, their whole, um, work, everything they've done to work towards this point, um, it could be completely lost because they're just getting up getting. You know, either killed or whatever. So this concept of risk and reward is, is playing itself out throughout the movie, but it makes me think of this idea of of having um maybe a few large or just, you know, one singular large client customer who is the concentrated party revenue and, and the risk and reward of that is you have an, you know, you make great money on it, but if you lose it, everything could go away overnight. So, So it really sets up this conversation to talk about what is customer concentration. And I'll start off with the idea of what is, what is it when you recognize it in your own financial statement? So a rule of thumb would hold that any single customer account that is 10% or more of your revenue, or if you have your largest 5 customers account for 25% or more of revenue, you have a high concentration, high customer concentration. So one of the activities you do early on in the ESOP process is you identify your customer list and your revenue attributable to that customer list in order to identify. Those concentrations cause they will base, they will be a significant part of the planning side. So, you might already know that information, but what I wanna make sure I convey really well in this episode is how much of a deal, a big deal it is, and how does it, how does it affect your ESOP deal? So let's just talk about the good, the bad and the ugly then. So the good part of having a large customer. As we probably already know, is that they provide great revenue to a company and can really be the focus of the company as it relates to customer service. And so it's easier to serve one major customer in some ways. It's very efficient and there's, it's much lower cost to have one major customer than having, you know, many different types. So if I can have that time and energy to spend focusing on that one customer, then it'll be, it'll be much more advantageous. And in other advocates of high concentration, when you think about the ability to develop long term relationships with fewer large customers and contractual agreements that can be tailored to each client, um, you can actually structure very strong customer relationships with fewer customers. So there's, there's a very good element of this in business and it's And it's true that I can have a stronger revenue base if I have stronger customer relationships. And so, um, we just have to understand the spectrum of that when it becomes too, when it becomes too much risk versus the reward that it presents to us as a business. So 11 other aspect of the, of the good side is that customers that are larger, we also can get into customer relationships where we're, we're becoming more of a partner and we're built stronger into their business model. So, Um, that can happen when you become a preferred supplier to a customer, and you can develop a better relationship in terms of how your business is functioning with their business. And so both sides will benefit. And so in that case, there's less risk um when you're baked into what they're doing and so that could be another aspect that, that I would say is good. So let's talk about the bad now. So that's the good, the bad is um high customer concentration really carries substantial risk that I'd say just kind of in general, we're gonna have to agree they outweigh, sometimes they outweigh any benefits in the long term. Um, it is difficult as we look at the bad side to turn away, um, revenue opportunities, um, especially when our business is in a growth phase and we're, we're using that growth phase to get ourselves to another level in our business so that we can um maximize profitability at certain levels, maximize and the GNA that we have in our business, for instance, and, and really become more and more profitable. But I would say that on the bad side, and this is, this is gonna be um also price spelled out in a lot of different publications, but particularly Forbes magazine has written many articles about this, that high concentration of customers is really one of the greatest risks to businesses. And um when, so when you start thinking about what they're saying when they compare all the business risks that we can come up with. Um, and putting it at the very top, that is why this is such an important topic for our episode. So, one of some of the reasons are losing a customer can have a devastating effect on revenue, profit and cash flow, um, and it can happen in a very short period of time. And even though agreements are entered into with really the best of intentions, sometimes fluctuations in the economy, um, sometimes pressure from competition, um, can get in the way. Losing, um, any client is undesirable, but losing 10% or more of your revenue at one time can really destroy a business. So it's, it's the timing of that and not having the ability. To, um, absorb that change in your business so abruptly that makes it a major issue. When a customer comprises a large share of your business, they can also Um, influence because of the pressure that they have over pricing, they can influence your profitability by putting a lot of pressure on you to reduce your prices. And so that negotiated leverage puts you in an unfavorable position as a business when you're looking at the potential for continued reduction of profits and cash flow. Large customers can also tend to divert a disproportionate share of resources away from your smaller ones. And so I know this has happened with a lot of clients where their business has grown, they start to ignore some of their smaller clients and then boom, they lose the big client for some reason, and then suddenly they're trying to go back and rebuild this, this, this customer base with a smaller group of clients and they've kind of moved on and they've gotten other suppliers or other um vendors to help them. So, the, the idea behind this is, is again, the risk and reward. Sometimes we get, we gravitate towards that larger customer and then suddenly, um they're taking more and more and more um of our time and energy and resources, and we don't even realize how much our business has kind of shifted towards just serving that one major customer. So, it's very important to have in this case, like the be understand to be aware of. This list of of items in your business where your smaller customers really do need to be taken care of and, and I'd say the the one thing about this really is this idea of monitoring your customer service really well and engaging with your customers across the board. So the other side, on the bad side, again, where as we stay on this is one continued theme of what, what is bad about this is, uh, this definitely can influence the way that, you know, of course, prospective buyers would look at your business or lenders or even investors, when they're assessing what's happening in your business, they're making um decisions based, credit decisions, for instance, from a banker's perspective about your business, um, depending on, on how they're looking at um what you're doing. And so having Uh, a great deal of concentration could definitely be viewed negatively from these different parties, and those are, those are, I guess, principally based on the, on the other bad factors, but this is just more of what this can do to limit my options and my business in terms of my next steps. If I need to borrow more money or as we start talking about the ESA, exit my business um or raise money as investors, those are all gonna be limitations with high customer concentration. So the ugly side of this is, is really that. It may take years of planning to get the right mix of customers to reduce this concentration risk. In some cases, as we evaluate the forecast, reducing reliance on one or two customers, um, really will mean reducing revenue and proportionately your ebi or cash flow, which will directly reduce your business valuation. And so it becomes the ugly part of this really is because you get into a certain corner with this. Everything you do actually is counterintuitive or counterproductive to what makes sense to run a good business. When you're consciously making choices to reduce revenue and reduce labor and reduce, you know, your ultimate profitability and the growth of your company, um, if you go too far down the road of concentration, customer risk, then this becomes really ugly when you're trying to get back to diversifying that mix. And so, um, the ugly part is too that you, as you start to think about moving that, moving that process to, to improve it. Um, it really does become a longer process. So, so this really begs the question on the ugly side. It's like, when do you start looking at customer concentration? And if you have a transaction on an ESOP that's gonna be, you know, next year and you have a high customer concentration. I, I'm gonna just say it's too late because you're in a position where you're really wanting to transact and that's gonna be something we're gonna have to deal with in the, in the actual structure of how we go about trying. To sell to the ESOP. And that there will be some negative ramifications in that. But if I have a 5-year window, the ugly part gets less ugly because I can really start planning out before I go through this process, or even a, even a few years, still would be better to, um, to start to alleviate the pressure of that. So if you look at the um the nature of, uh, you know, business valuation being impaired, um if your business is in this position where they have lots of concentrations, so some of the questions that I would ask in evaluating um your customer concentration are going to include, what, what is the contractual nature of the customer? And the reason this is important is just that there's obviously degrees of customer concentration and what matters in risk assessment is to really understand the details behind it. So it's not, hey, I just have customer concentration and my number, my percentage is this, and I really want to have a lower percentage. It's more of, of the details behind your customer relationships. So, If I have a customer that has very high contract, contractual obligation to me as this, as the supplier or the vendor business, and they're um obligated under that legal contract, then obviously, I'm gonna have less risk than a company that has just high customer concentration. What is the customer strength? On the other side of that was, if I'm doing business with a customer that's really heavily leveraged, and they're overly dependent on certain aspects of the economy that make them a very risky business. And I'm building my my company around with high concentration risk around their business. What's happening is I'm really building it around their risk profile. So it goes both ways. If they're really strong, then it's going to become a lesser of a risk if they're really weak in those areas and, you know, they've been affected by the economy and like if you look at the economy right now, companies that were, you know, fully focused and concentrated in hospitality, for instance, are going through a very big downturn. Companies that were really focused in on support to hospitality or support to restaurants and Um, different restaurant chains, those are gonna be affected greatly. And so even though it may feel, uh, you know, at one point that these are really strong entities, um, we never know what the industries and the economies, how they all can switch so quickly. So customer strength is gonna be very important to analyze and to better understand the concentration. And then what's the extent and history of this relationship with this customer? Is it, does it go back for 25, 30 years, um, or is it just been the last couple of years where you've become more and more, um, they've become more and more reliant on you and your services or your products. And so, obviously, the years and the extent of the relationship is going to matter. And then within that, there's going to be um aspects of who in your business is dealing with that customer. So is it, Um, is it multiple people that are dealing with that business or is it just one person? So, so specifically there might be customer concentration risk, you know, even worse or even more um extensive if you have all of that in the hands of maybe one sales manager or even just the owner who's exiting the business, that might be an a further risk issue as well. The other ugly is that giving customer concentration, um, as it's evaluated by the trustee and their advisor, they're gonna want to shelter the ESOP from the risk of this exposure. And the most common way to do that is to incorporate a clawback into the deal, which is going to basically be a purchase price adjust adjustment in the event that there is a problem. So the downside for selling a selling shareholder and this is that they take on the transaction at the risk of losing part of the amount that they sold the company for. And so, how many people are willing to um take that risk. And if you understand customer concentration, you may not really have no choice in the matter when you get down to it if this is the path that you're gonna go on. And now you gotta get comfortable with that risk going forward. So what can a business owner really do to mitigate the risk of customer concentration? What steps should they take? So again, if we're, if we're dealing with a, a, a client who's thinking about selling in the near term, I think that's gonna change if you have some time in the planning process, which I get highly advise, then I think that would be um most, that would be also considered in terms of these suggestions. So the first would be diluting the percentage, and this is just an obvious, but diluting the percentage of concentration by increasing sales to other customers are entering new markets. So a question here when we talk about strategy, and we talk about business planning is going to be, tell me a little about your sales department and tell me about what the sales people are doing and on a KPI basis, tell me how many phone calls or outbound calls they're making, you know, on a weekly, monthly basis. And so those might be indicators that there's room for your sales department to grow the business. Outside of just those customers, maybe there's an incentive problem within the customer, um, in terms of your sales department where they're actually getting incentive on the larger customers, maybe we want to increase the sales incentives on those that non-primary customer and other customers that add new names to your, to your customer list. So certainly dealing with the existing sales processes are going to be an important step in terms of dealing with this business risk. So in an, in an extension of that then would be, OK, so corporate management then decides instead of just the sales department, what we're gonna do is we're going to increase revenue again, and we don't, we want to do this in a different way. We want to actually go out and purchase or acquire a business that could be either a compliment to what I'm doing, but certainly in the, in the con the concentration risk, the acquisition is targeted strategically. At diversifying the revenue away from not just this customer, but it might also be maybe even potentially a new service model, a new product model, a potentially even a new geographic area. So there's a lot of strategic um processes that would go into planning a acquisition, but ultimately, anything that they do that's not going to be to increase business with the same customer or the same group of customers. Or even concentration in that one industry is going to directly improve the total customer concentration issue. And so, Acquisitions take time, and they are expensive in some cases. You have to be geared up for them. And again, that would be difficult to pull off an acquisition and then do in the same year, your ESOP transaction. So that's kind of what I meant on the, the front end of that. So I, I touched on this a little bit, but I definitely would say in your, in your customer service delivery model, as it includes who's servicing that customer, who are the key people in your business, you definitely want to make sure you've checked the box on how many contacts that customer has within your business. And further than that, we want, we want to look at possibly employment agreements. If, if you can get employment agreements where you have Non-competees and non-solicitation rights, those would be very important because they're going to mitigate the risk of anybody leaving and taking that customer with them. So employment agreements are just kind of a way to mitigate other risks as well. So, and clearly what happens with, with the ESOP when the trustee buys it, if the trustee buys a business and the people leave, then there's gonna be obviously a major problem. So there's less risk for a company that has these existing employment agreements and that will directly affect customer concentration when you're thinking, when you're thinking about who has the responsibility related to uh those major customers. And a lot of times it's the owner that's selling it has those, and those relationships and those need to be transitioned as well in the process of doing your ESOP. And the owners would be in their selling process, they would also be signing in uh typically an employment agreement in the ESOP as well. Sometimes in this case, we're gonna have to go and reduce the limit of sales to a customer. This is really probably very, very difficult because when you have a customer and you and it's profitable, it's very difficult to say we're not gonna, we're gonna hold back, but in some cases, we as a business have to realize we, we need to go ahead and really build relationships with these some of these smaller companies or smaller customers and this gets in the way. So, I don't love that idea, but I do think it's important to consider as, as you start to build your business plan. Other things that you can do to, to, to reduce the risk or mitigate the risk is really enhance that relationship with the customer that you are really viewed as the key vendor and in this process, they and make it as difficult as possible for them to just up and leave. So that that part of the risk, the business risk of them going out of business as your customer that you can't get away from that, but the business risk of them just leaving you, you can mitigate by Building more processes with them and help and basically as you can help them with what they're doing as much as you can, um, it may be the billing process they go through, it may be the order process that they have and how you integrate that process with your people may strengthen. So anything you can do to strengthen and enhance the connection and the bond you have with that customer is going to mitigate this risk. So some other financial side would be consider purchasing credit insurance um on the customer. So if you have um concerns from the bank side, then this may ease the bank's mind in terms of how much uh concentration you have within your account receivable, but that's not as much directly to the, the ESOP transaction only because it's still gonna kind of have this, this customer risk. the, the insurance is really gonna benefit the bank in that case. But all in all, there are multiple things you can do to mitigate the risk, but taking a really an ugly situation and trying to make it look pretty when you get down to it. And so, what we're trying to do within this is say, do not put all your eggs in one basket, which is a kind of a famous idiom. And it really kind of, what I would like to do is just coin that into um a very common nursery rhyme, which is Humpty Dumpty sat on a wall. Humpty Dumpty had a great fall. All the king's horses and all the king's men could not put Humpty together again. And the idea behind this is you can't expect to have, uh, you know, no problem if something happens and you're putting all your, your eggs in one basket. And we really do need to be aware of how to mitigate risk related to that. And so as we close this episode, I just wanted to say again, thank you for, for listening to the podcast. Please rate it, uh, please subscribe to the podcast as well and share it with a friend, and we'll look forward to our next episode. Thank you so much.