Diversification Within the Private Company
All investors, including business owners, should use diversification as a defense against random and unforeseen events. You've placed your money in what is called "private equity," i.e., your business. You must work to achieve meaningful financial diversification by investing outside of your business, but you should also use the law of diversification within your business to fortify and protect the business.
What would be the impact on your companyif you lost your largest customer? If the answer is "severe," then you bear customer concentration risk1. Do you think you have an exceptionally strong relationship with your largest customer? If so, can your relationship prevent such things as fire, fraud, death, divorce or change of ownership? Probably not.
Contrary to what many owners think, diversity is achievable. It may take years, but once you secure customer diversity, then you have significantly increased the chance that your company will be around for the long run. You have increased its value, too.
Most regular acquirers of companies consider 10% to be the threshold between healthy customer diversification and concentration risk. If the largest customer, or any customer, accounts for more than 10% of annual revenues, buyers typically reduce the price they're willing to pay - to account for customer concentration risk. Business owners should use this gauge, too.
What industry do you serve? If you could answer this question with the name of a single industry, then you bear industry concentration risk. Only companies that sell into multiple industries enjoy industry diversification. Over time, small companies should identify and penetrate multiple industries. For example, a printer that specializes in Baptist church books and magazines should expand to other denominations, then expand outside of faith groups to produce corporate annual reports, for example, or travel-related magazines.
The "category killer" of the 1800s, U.S. Saddle and Whip Co., no longer exists because of its failure to diversify its product lines. If the company had only diversified into other types of leather goods, such as automobile seats or driving gloves, its great-grandchildren might be graduating from Harvard Business School today and managing the family foundation.
Reliance on a single, or a few, talented employees has caused the failure of more than a few companies. A private company owner should do all that he or she can to reduce exposure to the sudden departure of key employees. First, consider key-man insurance to insure against death or disability of key contributors. Next, break up key tasks performed by your most critical people and spread them around to as many people as possible.
Private companies that purchase unique items or services from a single vendor, or purchase components that would be hard for another company to duplicate, may bear significant risk. Take your key vendors and ask yourself, "If XYZ vendor burned down or closed due to financial problems, how would my business be impacted?" If the answer is "greatly," you need a contingency plan. You should consider insurance, and begin plotting a course of action to mitigate this random risk exposure.
The lifeblood of many businesses is their source of funding. What if your banker pulled your line of credit, or your largest vendor stopped offering you attractive payment terms? During difficult economic times, credit sources can dry up unexpectedly. Business owners should recognize credit risk and work to ensure that this lifeline remains extended.
The business cycle tends to roll through industries and geographic regions in a less-than-uniform manner. If all of your customers are in a single state or country, you bear risk associated with your lack of geographic diversification. Try to find customers located elsewhere.
1 Concentration risk is lack of diversification in revenue or profit sources.
Copyright © 2011 by D.L. Perkins, LLC. All rights reserved under International and Pan American Copyright Conventions. Reproduction, in any form, in whole or in part, is prohibited without written permission from an officer of D.L. Perkins, LLC. Issn. No. 1556-2026. Vol. 6, No. 4. "The Business Owner" is a registered trademark of DL Perkins, LLC - Registered in U.S. Patent Office
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