Supplier Risk

Regular readers of this column will know that we’re gradually shifting away from pure theory around how to value your business and increase its potential, to more of an interactive discussion around the financial/valuation/strategic issues that entrepreneurs face. What this means is this:

If you have a question/issue you’d like to discuss with us, then send an email to finweek@valuationup.com and we’ll try to answer your questions in this column. This could be anonymous (if the numbers/industry or problem is particularly sensitive – this is entirely your call), it could also be public – in which case you’d get the added benefit of your name, company and what you do in print. As a wise man once said, there is no such thing as bad publicity.

One of the greatest things about my work is that I get to spend time with ambitious entrepreneurs, generally at a time when they are experiencing a real challenge and need to get help to make more informed choices. Like all ambitious people, they have a view of their business and their worth that is not always bedded down on reality and no-where is this more true that in their perception of the real risks they face. This is exactly what’s happened in the last month with 2 such entrepreneurs I’ve worked with:

In the first instance, I met with a BEE company that has the rights to distribute a leading international product into the public sector. Their supplier has other distributors who sell to the private sector (not so BEE) and has other BEE distributors who get exclusive rights to sell some of their smaller products. The company I met with have grown nicely for 5+ years. They have a great relationship with their supplier to the extent that the supplier even gave them a R10M working capital facility to help them when government paid slowly (of course, they ceded their debtors book as part of this deal). Things were good and they made a few million PAT a year…until last year, when the supplier changed its terms and cut the margin a bit. This year the supplier has come back to them with ambitious growth targets they have to meet or else they will terminate the contract. The problem is they can only sell to the public sector in an industry that isn’t growing nearly as fast as inflation and that is extremely price sensitive. In other words, they are up the creek without a paddle. So what are they doing? They are scrambling to open doors with other suppliers, which sounds good until you remember that the supplier owns their debtors book that will include the new suppliers. So they are faced with the only real choice – they have to do what they can in the existing business but open a new one in parallel. Whether they can eventually get a cent from 5+ years of hard work in their existing business is uncertain, but unlikely. Would you buy their business? For what?

So what happened there? Supplier power, coupled perhaps to the unintended consequences of BEE legislation and entrepreneurs who couldn’t understand the risk of having all their eggs in one basket, especially when it was going so well.

In the second instance there is another entrepreneur in another unrelated industry. He’s built a great team and great testimonials. They represent a sole supplier in the local market but have no exclusivity on any market or territory. They’ve literally sold their way into where they are now: building relationships, delivering on time, and delighting with customer care. They’ve made some money and want to start acquiring the other distributors of this suppliers’ product here. In theory this sounds good: they can buy market access from underperforming distributors and roll out their operational excellence to these new markets and thus make more money. I like their ambition, but I really don’t like how they are increasing their risk. You see, people forget that systems respond when their components change. So you have to look at what their plans might do to the market. As they buy their smaller competitors they become bigger, but still with only 1 supplier. So there is increased risk that a competing product could be launched that would rapidly take market share away from them, but the greater risk is that their supplier will wake up to the fact they are now represented by only a few distributors, one of who has over 80% of the market. The distributor then faces 3 choices: they can continue as is with a lot of risk in one basket, they can push more business to other existing or new distributors, or they can buy their largest distributor and bring this all in house. A lot of this is going to depend on the suppliers’ strategy, not the entrepreneurial distributor. So how much control do they really have? If you were to buy this business would you be happy that 100% of your revenues depended entirely on 1 supplier? If you were to lend them money so that they could buy their smaller competitors would you consider this high risk or low risk? Would you not want them to have other suppliers whose product they could offer to their market?

In both these examples, there are businesses that look great on the outside. They’ve grown consistently (at least until last year); they’ve increased market share and profits. However in both cases they’re entirely dependent on 1 single supplier who effectively controls how much profit they make. There are no guarantees in business, but there’s a high probability that serving a single supplier puts your business at huge risk.

How many suppliers do you have? How will you mitigate that risk?