How locked-in are your Customers?

A while ago I was working on a deal. A large foreign company wanted to buy a stake in a local company, lets call them “MoneyCo”. I had introduced the parties and was representing MoneyCo. The discussions were warm and friendly and as more information was shared the proposed deal moved from the foreigners wanting to buy a small stake to an outright acquisition. The deal moved from discussions to a formal Heads of Agreement with preliminary approval from the M&A arm of the foreign company, to a signed term sheet and then due-diligence. The whole process to date had taken under 6 months; in other words, the deal was moving well and at typical pace for something involving people who travelled a lot and who had other things on the go.

Deals fall apart in due-diligence, and we had reason to be worried: MoneyCo had been using their clients to fund their working capital, which is something every business does but in this case they were paying their customers on 90 days when their contracts stipulated 30 days. It had got to the point where the business had negative working capital and any growth was funded by simply paying all clients a day or two later. In fact, sorting out this mess was one of the key reasons MoneyCo was considering being bought out in the first place. The end customers were big companies and they squealed loudly about the payment terms, but each month MoneyCo made sure they got paid something (even if they avoided the phone once payments were past due)!

We were worried that if we did a deal we’d first have to bring clients up to current payment, i.e. to sort out the working capital mess. This would have required several Million of the deal to go straight back into the business. More than that, we were worried that MoneyCos’ clients would switch to another provider entirely and that revenues and the deal would collapse. This worry was shared with the buyer and was a key question to be explored during the due-diligence.

The foreign companies advisors conducted a series of interviews with the major clients of MoneyCo to explore this and other issues. They asked questions designed to question the satisfaction of the client, plans for future business, and the stability of the relationship. What came out very strongly, is that the clients had no intention of moving and were comfortable with the relationship, some even talked about plans to increase the volume of business being done with MoneyCo.

Before I tell you what happened with the deal, lets look at how MoneyCo was able to get away with such late payments. Several factors were at play:

  1. MoneyCo clients were foreign companies who couldn’t operate directly in the local market (not by law, but because a major supplier chose to only allow a few local companies to distribute their product and all others had to go through those).
  2. The local market was small compared to some other markets the foreign companies were in, which meant that the parent could absorb some of the working capital issues in the local market.
  3. MoneyCo had competitors, but they charged more, were less reliable, offered less customisation, and were slow to respond on a technical level. In comparison the technical team from MoneyCo allowed clients to walk in and out of their offices and make system changes almost real time (the issues this caused are for another story).

What all of this meant is that these big companies traded off the level of service and custom product offering they received from MoneyCo for the reality of being paid very late. As the customisations gradually built up over time it became harder and harder for them to switch to a competitor, and essentially MoneyCo had sufficient power over the customer to force them to accept late payment. The clients would respond with downward pressure on the fees charged, but the reality is that they weren’t going anywhere.

So what happened to the deal? Well, the fact that the major clients were happy and stable and weren’t going to leave MoneyCo at the drop of a hat meant that the foreign acquirer was happy with the risk. However it also meant that without a potential call for immediate payment by MoneyCo to one of its biggest customers (which would effectively have put it into liquidation), the urgency to do a deal fell away for MoneyCo and on consideration they walked away. Some time has passed since then and I hear from someone that they are now paying their customers on 120 days…

Customer concentration and customer switching is a very real risk for any business. Most times, customers can easily switch to another supplier. What about your business? How many customers do you have and how easily can they take their business somewhere else? Why do they really buy from you?