Monday, August 21, 2017

Attractive Acquisition Attributes – Part Three, Diversification

As we explained in our series titled “Low Risk is the Key to Valuation,” any business attribute that lowers acquisition risk also increases value.  By definition, this type of attribute is an attractive acquisition attribute for buyers.  In previous posts we have described how consistency and recurring revenue are attractive to buyers and increase the value of your business.  In this post, we will explore why diversification is attractive to buyers.

Diversification can apply to many aspects of a business but the one overriding goal of increasing diversification is to reduce the risk of some sort of disruption to your business.  Whatever the source of “concentration,” the opposite of diversification, it should be evaluated to see if there is a way to create more diversification.

When we discuss diversification with business owners the discussion usually begins with a focus on customers.  Frequently, one of the first questions we get from prospective buyers is whether there is any customer concentration.  This is so common that we always address customer concentration in our offering memorandums when marketing a business.  The level of concentration where buyers begin to get concerned varies from business to business and sometimes industry to industry.  Usually a customer that represents 10% of total revenue is not too big of a concern.  When one customer is more that 20%, buyers begin to get concerned and may discount the price more because of this increased risk.  Customer concentrations above 30% can kill a deal or negatively impact value to the point that a sale is not attractive to the seller.  High customer concentration can also cause the buyer to defer part of the purchase price and tie its future payment to that customer’s retention, over time.  Do whatever you can to decrease your reliance on any one customer.

Supplier concentration is another key area.  Any business that is dependent on one source for any of its raw materials runs the risk of business interruption if that supplier is unable to continue to provide its raw material.  This could be caused by one of several different factors that are outside of your control such as natural disaster, an interruption in their own supply chain, labor strikes, financial problems and many others.  The message here is to establish secondary sources of supply and use them on an on-going basis to keep them interested in your business.  It is always easier to establish a new supplier relationship when things are going well than when you have your back against the wall.   

What are some other ways you could diversify your business? 

  • Different Markets – Are there other industries that you are currently not selling to that would find your product attractive.  For example, a manufacturer of industrial adhesives who sells primarily to the automotive industry may be able to expand in to the aerospace industry.
  • Geographical Diversification – If your current revenue stream is concentrated in one geographical location, explore opportunities to expand your geographical reach.  If your business is reliant on a physical presence in the markets it serves this would involve opening a branch location.  If not, it may be as easy as hiring additional sales representatives to target a specific geographical market.  Expanding overseas is frequently a diversification/expansion strategy that domestic businesses use to diversify their customer base to other parts of the world.  An additional benefit of international diversification is the economic cycle diversification it provides.  World economies seldom expand and contract at the same time so having customers in other parts of the world could soften the effects of a domestic recession.
  • Product Diversification –  Are there ways you can add products or modify your product to broaden your appeal to more customers?  Adding a related product that your current customers would find attractive is a good way to strengthen customer loyalty and get them to buy more from you.  Another strategy is to slightly modify your product to appeal to a different customer group.  For example, if you have a high-end product; develop a less expensive version.  Be careful not to encourage your current customers to move down market but it is a common strategy to have a “professional version” and a “hobbyist version” of the same product, with different benefits, features and price points.
  • Sales Channels – Have you thought about diversifying your sales channels to reach a different audience?  Opening an on-line store, for example, might be a viable strategy.  If you don’t offer your products over the Internet, add an e-commerce element to your website.  If you already sell online, look for strategies to sell online through different channels.  Look at the various “marketplace” programs at major e-tailers like Amazon. Consider opening an eBay store, especially if you have miscellaneous overstock items in your warehouse. Rather than marking them down to next to nothing and undercutting new products, sell them on eBay.
There are many other areas that you should also assess for risk reduction strategies.  Think outside the box.  For example, how important is an uninterrupted electrical power supply to your business?  How expensive would it be if your facility was shut down for a day or even a few hours due to an electrical outage?  Installing a back-up generator would address this risk and is a way to diversify your power source.

These are just a few thoughts on reducing risk and increasing value through diversification.  Every business is different and we would encourage you and your advisor to assess your business for risks created by lack of diversification. 

Alan D. Austin, CFA

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