Can your customer base impact the value of your business? Absolutely!
Your customer base’s size, loyalty, profitability, growth potential, business risk, and brand image all impact value. The risks associated with customer concentration or high customer churn can decrease its value.
Here we identify several customer-related valuation drivers and provide suggestions to minimize those risks with the goal of maximizing your company’s value.
Identify and Improve the Factors to Increase Your Company’s Value
- Growth Potential. A growing customer base signals you are successfully attracting new customers and expanding your market reach. Increased revenues and profits follow.
- Brand (or Reputation). A reputable brand attracts customers, differentiates the company from its competitors and may allow premium pricing. These are reflected in the company’s stronger financial performance and higher valuation.
- The company brand is what counts, not the reputation of the owners in determining the value of a company.
- Customer Loyalty. A loyal customer base shows low churn (turnover). Loyal customers refer other customers to you. They provide positive reviews and helpful feedback. A loyal customer base creates a more stable and predictable revenue stream. This enhances value.
- Repeat Customers. Selling to customers who have already bought from you is by far simpler and less costly than a cold sale. Focus marketing resources on growing your repeat business and track these metrics! A high rate of repeat business lowers risk and increases company value.
- Recurring Customers. These customers purchase your products or services on a regular schedule. A predictable revenue stream from recurring customers decreases risk in a company’s cash flows. It increases company value.
Ask for reviews and publish them. Ask for referrals. Are incentives for referrals a viable option for your company? If so, implement them. People like to help others.
Understand and Resolve the Customer Risk Factors that Reduce Your Company’s Value
Customer Concentration. You rarely turn away business from a large customer. There are associated potential risks, though, that can lower your company’s market value. Does any single customer account for 10% or more of revenues (or gross profits)? Do your largest 5 customers account for more than 25% of revenues (or gross profits)? These concentrations can be mitigated by contracts, the fact there are no or few quality competitors and by long-term relationships. (These percentages are just examples; your situation may differ).
Two identical companies are up for sale. They report similar revenues and margins. Company One receives 35% of its revenues from one customer. Company Two has no more than 5% of its revenues generated from any one customer. All else equal, the Company One is riskier and less valuable to a buyer.
What’s the impact of these types of risks?
- Cash Flow Risk – If one or just a few key customers reduce their orders or even stop doing business with you altogether, it can be devastating. Replacing that revenues stream may be difficult.
- Accounts Receivable Risk – If a key customer faces financial challenges, it may have a negative impact on your receivables and cash flow.
- Margin Risk – Key customers can (and do) exert downward pricing pressure and wield negotiating leverage that smaller customers cannot.
- Lack of Innovation. Over-reliance on a few customers can result in a narrow focus on meeting their specific needs. This may hinder a business’s ability to develop or improve products and services or to explore new markets.
How to minimize the risk and increase value
Implementing these initiatives will improve your company’s cash flow, making it more consistent (and less risky), driving up your company’s value.
- Can contracts be put in place to minimize risk? Often, contracts have termination clauses that provide some lead time. This gives vendors the time to replace the revenue stream from a departing customer.
- Margin Analysis. Compare the profitability of your current focus on customers, industries, and geographical markets to what you may earn by dedicating resources to win new customers, provide new industry applications, and enter new geographic markets. The rewards of diversification include sales growth, potentially higher margins, and diversification of risk. The risks include the cost of these dedicated resources.
- Diversify sectors in which the company operates or expand your product and service offerings, opening up to new potential customers. Think outside the box. How will my product or service provide value to a different industry or customer base? To be effective, you must be an expert in the market your company is expanding into and provide value to the end customer.
Business is strong, your backlog is rising. But in the background lurks the stress to find your next lead. Especially when times are uncertain, like right now!
Without new leads, a business cannot increase its revenues. Right? Wrong!
We all believe companies that depend on one-time sales or projects must constantly seek new leads. This is a huge investment of time and money with a questionable rate of return.
Do you really need to only find new customers? Not at all. Your gold mine is your current customer base.
Do you maintain contact with your customers? Does someone call or email them routinely just to see how things are going? If you are not ‘salesy’, most clients appreciate your keeping in touch.
We all hear of a salesperson calling a customer and learning they need something that your company offers, and they didn’t know.
Existing customers are already sold on you. If you can sell existing products and services or solve their other pain points, their decision to buy from you is a slam dunk! Sales are up, profits are up, marketing costs are not up!
A significant repeat customer base is a huge selling point to buyers. A buyer looks at how risky the revenue stream is. Less risky companies are those with a strong base of recurring customers. A more predictable view of the future from this consistent cash flow results.
A second option is to see what other services and products you offer that your customers may need. Create a list of your customers’ pain points. What products and core competencies and skills do you have that will solve these pain points? Do you have an existing product or service offering to provide? If not, refer them to others who can assist. You’ve created goodwill both with the customer and the referred company.
The adage Give to Get really works.
Does the value of your business reflect all the work you put in? Probably not. Shouldn’t it? Absolutely.
Business owners sacrifice for their business – no nights out with friends, skipped weekends with their kids. All to grow their business.
Owners look to the business’ ultimate selling price as the reward for all their work and sacrifice.
Then comes the offer: “That’s all??”
Owners who poured their heart and soul into their company often do not get the return they expect or deserve. Owners who were selling rethink that decision.
The worst in our view is when owners reached a burnout point where they just want to move on. At any cost. Right now. Some are willing to just walk away.
That’s the worst time to realize you could have taken steps to improve today’s profits and increase tomorrow’s selling price.
Can this be avoided? Yes.
Is it easy? Nope. But when is being an owner easy?
These are some key factors buyers will consider in making an offer for a company. By proactively addressing them, owners can refine their business so it has the most value possible. The bonus is their profits will increase near term, too.
Buyers acquire companies with the least amount of risk. Reliable recurring revenue streams greatly reduces risk.
Recurring revenues assure the company will have predictable cash flow. To optimize your revenue stream, identify and focus on recurring revenue opportunities. Not so simple but very valuable.
You have developed relationships with recurring customers. You’ve marketed to them once. Keep them happy and they stay. Marketing to a new customer often eats up 10% of revenues. Marketing to existing customers is much less costly.
Predictability is crucial in running a business. Processes contribute to predictability.
Repeatable processes assure the buyer the company will function effectively without the direct involvement of the former owner.
A business with no documented processes holds a lower value. The value it does have is associated with not the business but with the employees. Only they know how to handle the workflow. This is a risk to a new owner.
With repeatable and documented processes, the value belongs to the business. New people can readily learn how to best perform their jobs. There are fewer opportunities for error or “I forgot” situations.
The goal of creating and documenting processes is to keep it simple. While it sounds harsh, any individual employee should be dispensable. Especially you.
Diverse Customer Base
There’s no bigger red flag for a buyer than a company that relies on a few (or even a single) customers. If those customers move on (and it does happen), how much is your company now worth? Little to nothing.
To be attractive to potential buyers, diversify your customer base. Diversity applies to the industries served as well as the customers themselves.
The more diverse your customer base, the more options a company has when external challenges arise. The COVID pandemic, for example, slammed some industries and led to explosive growth for others. Spreading your risk leads to more stable sales and profits.
How to diversify? Look to expand into new sectors. One way is to simply expand geographically. Then, think outside the box. How could my service or product provide value to a completely new set of customers or industries? What about complimentary services? Is there something close to your core competency that is an obvious add-on?
Let’s say you produce hinges for kitchen cabinet makers. Why not sell to cabinet makers for marine applications? If your products can be easily adapted for use by a new segment, go for it!
Think like the potential buyer of your business. Would you want a business that has room to grow or one that has reached its ceiling? The choice is an obvious one though few business owners consider this.
Investopedia defines scalability as “a company’s ability to grow without being hampered by its structure or available resources when faced with increased production.”
Scalable businesses have higher profit margins. Overhead increases at a much slower rate than sales.
Improving Cash Flow
Buyers like companies with a stable cash flow but LOVE those with rising cash flow.
Addressing the suggestions in this article will create higher cash flow. Look for profit leaks (those practices your business has that leak cash but do not improve the bottom line). One example is addressing slow paying customers. If they consistently pay late and require a lot of follow up, are they worth being your customers?
Your CPA can assist finding these leaks.
Entrepreneurs should think about the end value of their business throughout their business’ life. Steps such as these not only add to the endgame sales price, but they also increase your profits today.
While the proverb “Every cloud has a silver lining” is always true, sometimes it’s hard to find the silver lining. Where is that lining for business owners?
In the last twelve months, the S & P 500 Index ranged from a high in April 2022 of about 4,462 to a low of about 3,577 in October 2022. It somewhat recovered currently to the 4,129 level but is volatile and down overall as of the writing of this article.
The value of privately held businesses may be rising and falling, too. Valuations of privately held businesses are influenced by the investor expectations, which are reflected in stock market returns.
“That sounds like more bad news, so where’s the silver lining?”
If there are plans to transfer equity interests to family members, now may be the time.
The federal estate tax exemption, which covers gifts, too, allows an individual to transfer up to $12.92 million in value without incurring any gift tax. If married, a business owner and their spouse can transfer up to double that, or $25.84 million. The amount used through gifts is applied against the value of the remaining assets upon death. (Note that states have their own and varied rules and taxes).
While $12.92 million and $25.84 million are huge amounts, business owners typically hold other significant assets. The more they retain with their federal exemption, the better.
Note that the current exemption expires on December 31, 2025. While that’s a long way off, with politics involved, you never know if that expiration date will stick.
It’s rare we receive a present from strangers, but the IRS of all sources routinely provides one to surviving spouses. The assets surviving spouses inherit from their deceased spouse can be stepped up to fair market value, with no federal estate tax impact!
Why don’t spouses take advantage of this? If the Estate is not federally taxable, as often occurs when the surviving spouse is the sole heir, there is no need for federal estate tax requirements to calculate the fair market value of these closely held business interests. But this is a potentially huge future tax-saving opportunity.
With no support for a step up, the tax basis to the surviving spouse is the decedent spouse’s tax basis at their date of death. In many instances, this is well below fair market value.
(If the surviving spouse subsequently gifts any ownership interests, the recipient’s basis is the pro rata share of surviving spouse’s basis. The fair market value determined at the date of the transfer is applied only against the surviving spouse’s federal estate and gift exemption. It is not a step up to the recipient. Not fair, but that’s the rule!)
Here’s a simple example.
Mary owns a privately held business. Her sole heir and surviving spouse John and their children continued to operate the business after Mary’s death. Because there is no federal tax impact, no step up valuation occurred. The basis for federal income tax/capital gains purposes for John is the tax basis of the decedent spouse, in this case, Mary.
Mary’s tax basis at her passing was $250,000. But the business was worth $1 million and no step-up valuation to back this was performed.
Down the road, an offer to buy the business for $1.5 million is accepted. Assuming no major changes to the tax basis, without the formal step-up, the potential tax on the sale is calculated on $1.25 million. Had the step-up been established, the potential tax is calculated on $500,000.
Of course, a retroactive valuation is possible. But such a retroactive valuation is subject to the passing of time and related information and management knowledge “black holes”. A valuation nearer the date of death would avoid these information gaps.
Which tax scenario would you prefer? Even if the only tax is the lowest capital gains rate of 15%, the savings are huge! All that is required is a filing for portability with the IRS
|At the Date of Death
|Ultimate Company Sale
|Ultimate Company Sale
|No Step Up
|Fair Market Value
|Gain Subject to Tax
|Capital Gains at 15%
The classic 1978 film Up in Smoke relates the misadventures of Pedro and Man (Cheech and Chong) who unwittingly smuggle a truckload of marijuana from Mexico into the US. Today, marijuana is a highly-respected and highly profitable business. An evening stroll in many areas typically includes inhaling secondhand smoke!
Bank of America Securities reports industry sales at $25 billion in 2021. Industry experts see it rising to $100 billion by 2030. While these stats include CBD which is more readily available and less regulated, the dollars are quite staggering. Many believe this industry is not influenced by the trials and tribulations of the economy.
Cannabis companies include retailers, cultivators, and processors. Several companies participate in all these segments. With some exceptions, such as those in California and Colorado where legalization has been around for several years, these companies report low or no profits. Their investors are betting on the future.
While challenges exist on the local and federal levels, more states are legalizing medical and recreational use. Local governments can impose their own restrictions. Landlords are frequently reluctant to lease to cannabis shops, fearing those store “attract the wrong kind of people.”
Valuations of cannabis companies are challenging for some. The data out there to support a valuation, while growing, is limited. Much of this data sources from Canada. The various restrictions that can differ by state lead to issues of comparability with databases of private transactions. Many cannabis companies are startups. Not only is there the higher risk of failure, but operating profits are also often low or nonexistent.
When considering the value of these firms, an analyst must look to the future. What will the company earn over the next few years? This is a valid valuation technique that, in its best form, can be speculative. A lesson many learned from COVID is the future may have a very unexpected twist. With cannabis companies, add in the struggles between entrepreneurs and legislators, the still-extant federal restrictions, and the growing inflow of competitors. Add to that the possibility that Big Tobacco will become increasingly involved!
JBVal has successfully performed valuations for cannabis companies ranging from dispensaries to cultivators to cannabis conglomerates. Our valuations have been vetted by auditors and have been utilized buy sell agreements, gifting and more.