Customer concentration and other risks that change the price

Two companies with the same owner earnings (profit plus what the owner pays themselves, before loan payments and taxes) aren't worth the same. One might earn its money from hundreds of customers with a team that runs itself. The other might depend on one big contract and an owner who does everything. On paper they look alike. The first is a much safer purchase.

Small companies are usually priced at some number of times a year's owner earnings. Risk is what moves that number down, or changes how the deal is put together. Here are six to look for once you have the company's documents. (If you don't yet, start with the financial documents to ask for.)

1. A few customers carry the company

What it is. One customer, or a handful, accounts for a large share of sales. Think of a commercial cleaning company with one big office-park contract. If that customer leaves, a big piece of the earnings leaves with it, and you still owe the loan.

How to check. Ask for revenue by customer for three years. Look at the share from the top customer and the top five. Then ask about each big one: Is there a written contract? When does it end? Can they leave on short notice? Is the relationship with the company or with the owner personally?

What to do. Price it in, or share the risk with the seller (more below). With the seller's permission, and usually late in the process, meet the biggest customers before closing. On purchases of $3 million or more, the SBA requires the lender's earnings review to assess customer concentration, so a lender will look at this too.

2. The owner is the business

What it is. The owner makes the sales, writes the estimates, knows every customer by name and fixes what no one else can. That knowledge doesn't come with the keys.

How to check. Ask what happens when the owner takes two weeks off. Who answers the phone, prices jobs, signs checks? Ask for an organization chart, even a rough one. Listen to whether the owner says "I" or "we" when they describe how work gets done.

What to do. Plan a real handover. With an SBA loan, the seller can't stay on as an owner or employee after a full purchase, but they can be paid as a consultant to help with the transition for up to 24 months in total. Agree on what they'll do, and for how long, before you sign. A deeply owner-dependent company also deserves a lower price.

3. Key employees could walk

What it is. The lead technician, the estimator or the office manager who has been there for 15 years holds knowledge the company can't easily replace. A change of owner is a natural moment for people to leave.

How to check. Ask about tenure, pay compared with the local market, and whether anyone has an employment agreement. Ask who would be hardest to replace and why. Meet key people when the seller is ready to tell them, which is often late in the process.

What to do. Budget for keeping them, perhaps with a raise or a bonus for staying through the first year. Our post on keeping the team after you buy covers how to approach them.

4. The equipment is worn out

What it is. An owner planning to sell may stop replacing trucks, machines or computers. That raises profit for a while, because the spending doesn't happen. The cost doesn't go away; it lands on you.

How to check. Get a list of equipment and vehicles with ages, mileage and condition. Compare recent equipment purchases with earlier years on the tax returns. For equipment-heavy companies, pay for an inspection.

What to do. Estimate what it will cost to catch up and either take it off the price or plan to fund it from your cash. SBA rules require the earnings review on larger deals to document deferred maintenance (repairs and replacements put off), and lenders can adjust earnings for equipment spending the company hasn't been funding. Our post on add-backs shows how this changes owner earnings.

5. Sales or margins are slipping

What it is. Revenue or profit has fallen over the last two or three years, or this year is running behind last year.

How to check. Put three years of returns and this year to date side by side. Find out why any decline happened: a lost customer, an owner slowing down, rising costs that weren't passed on, a shrinking market.

What to do. Price the company on what it earns now, not its best year. This also affects financing: for an SBA loan, the lender measures whether earnings cover the loan using the last full year or the average of the last two, so a falling year can shrink what you can borrow. An owner who has simply stopped chasing new business may be leaving you room to grow it. A shrinking market is a different story.

6. The license belongs to one person

What it is. Many companies can only operate because a particular person holds a license. In Florida, a contracting company, such as an HVAC or electrical business, has to be qualified by a licensed individual, called its qualifier. If its only qualifier leaves, Florida law gives the company 60 days to qualify a new one. For most construction trades, it may not do any contracting in the meantime unless the licensing board grants a temporary certificate to an officer such as the president, and that only lets it finish contracts it already had.

How to check. Look up the company's licenses on the Florida DBPR's website, myfloridalicense.com, and note whose name each is in. Ask whether that person is the seller, an employee or someone else.

What to do. Have a plan before you sign: you get licensed yourself, or you hire a licensed person who will qualify the company. Since the seller generally can't stay on as an employee after an SBA-financed purchase, they're an awkward long-term qualifier. Talk it through with your lender and attorney, and check it against the licensing board's rules.

How risk shows up in the deal

Risk can change the price, the structure, or whether you buy at all. Say a company has owner earnings of $300,000, and you'd otherwise value it at about 3 times that, or $900,000. But one customer brings in 40% of sales.

• A lower price. You might offer about 2.5 times earnings, $750,000, and explain exactly why.
• A different structure. You might keep the price at $900,000 but ask the seller to finance $150,000 of it over a few years, so they share the risk while the customer relationship passes to you. Our post on seller financing shows how that changes your cash and the loan. You may also hear about an earnout (part of the price paid only if the business hits targets later), but it isn't allowed when the purchase uses an SBA loan.
• Walking away. If the big customer's contract ends next year and they haven't committed to stay, the right price may be lower than the seller will accept.

How to ask about risk

Owners are proud of what they've built, and questions about weaknesses can sound like criticism. Frame them around keeping the company strong: "If your biggest customer had a problem with the change, how would you want us to handle it?" Owners who know their risks will have thoughtful answers. Owners who've never thought about them are telling you something too.

What to do this week

• Make a one-page risk list for any company you're serious about, with these six headings.
• For each, write what you know, what you still need to find out, and who can tell you.
• Look up the licenses the company depends on and whose names they're in.