SEARCH FUND RED FLAG: CUSTOMER CONCENTRATION
The search fund model works well with stable companies. Consistent growth, unlikelihood of technology disruption, good reputation, lack of large competitors, etc. Customer concentration is a clear red flag because it means that the company depends on a few customers.
When a company has customer concentration, the searcher should do at least 2 analysis:
1.- What is the relationship with these clients?
- How is the contractual relationship? If 50% of the revenues come from a client with a 20-year contract the risk is more controlled than if the customer could just switch to a competitor.
- How is the personal relationship with these clients? It could happen that over the years the clients have built a relationship with some of the employees in the company. This increases the risk for the searcher as she needs to make sure that these employees stay in the company or build her own relationships with these clients. Usually, the big customers of small businesses have contact with the owner. The searcher needs to ensure that this relationship stays the same when she takes over.
2.- How stable are these clients?
If the business depends on a few clients, the searcher needs to take a close look at them. How are their financials? How strong is their competitive advantage?
They become almost an extension of the company and they must be analyzed as such.
Even if the results of the above analysis are great, the fact of having customer concentration is still a red flag. To mitigate it, a searcher can try to offer a price that reflects this risk or get the owner to fix the problem. However, the owner will be reluctant to do this, especially if he is already actively trying to sell the business. And even if he achieves to reduce customer concentration, he would need do it by increasing revenues from other clients and the valuation of the company would go up.