Thursday, September 20, 2012

Key Value Drivers – Economic Dependence

Developing a business that is not economically dependent on a single customer, supplier or employee is a key value driver for many businesses.  Economic dependence increases business risk and decreases business value. 
Potential purchasers of a business are interested in the extent to which: i) sales are derived from one customer; ii) raw materials are obtained from one supplier; and iii) a key aspect of operations is dependent on one employee. 
Each of these is discussed briefly below:
1.   Customers
If a business is too dependent on any one customer, the loss of that customer can be devastating to the business.  Even with a contract, the customer could renew for a shorter period, renew under less favourable terms (e.g. reduced prices that squeeze profit margins), or not renew at all. 
Business owners should quantify the percentage of overall revenue generated by each customer. The strategic plan should address how to increase sales to the smallest customers or find new customers to reduce customer concentration.  The goal should be to have the largest customer represent no more than 10% of the revenues. 
2.   Suppliers
If a business is too dependent on one supplier, the loss of that supplier could be disastrous.  Alternatively, a price increase could squeeze profit margins (if not passed along to customers) and decrease business value.  A supply delay or shortage that halts production could negatively affect client relationships and destroy the business.
Business owners should determine their most important raw materials and, where possible, identify a number of different companies that could supply them.  The strategic plan should set out a plan for approaching and negotiating the same discounted rates from another supplier.  The company may be better off with numerous suppliers, even if some special pricing discounts are sacrificed.
3.   Employees
If a business is too reliant on one employee (e.g. management, sales, production, R&D, etc.), it is at significant risk if that employee chooses to leave.  The company will also be at a disadvantage when it comes time to negotiate that employee’s salary.
Business owners should rank their employees from easiest to most difficult to replace.  The strategic plan should address how the company can become less dependent on those employees most difficult to replace and how to create a bench of potential hires for key roles in the event of an employee defection.
In general, economic dependence refers to the balance of power between the business and a key customer, supplier and/or employee when it comes time to negotiate or renew a contract.  The more dependent a business is on any one customer, supplier or employee, the less power it will have in renegotiating a favourable contract.  This increases the uncertainty associated with a projected stable and/or increasing cash flow stream and inherently decreases the price a potential purchaser would be willing to pay for the business. 
If you are building a business to sell one day and are curious about where your business stands today, take the 13 minute Sellability Score questionnaire:

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