With a new CEO ascending to power and an old CEO ascending to space, there has been no shortage of Amazon-related headlines this week. But amid the leadership transition news, a less-prominent Amazon story is equally relevant to family business directors. A Wall Street Journal article revealed how Amazon uses its dominant negotiating position to extract warrants to purchase equity in suppliers.

For years, our clients have told us how purchasing groups at Wal-Mart pushed aggressively for price cuts. Our clients were grateful for the business but knew that holding on to that business and earning a profit on it required them to identify and root out inefficiencies in their own operations. Several clients reported that the discipline of supplying Wal-Mart had spillover benefits on other areas of their business. Now Amazon has added a page to Wal-Mart’s playbook, seeking to capture a portion of the upside accruing to shareholders by acquiring warrants in those suppliers.

A warrant gives the holder the right – but not the obligation – to purchase shares in a company at a fixed price at some future date. Because the price is established today, but doesn’t have to be paid until the future, the warrant holder shares in the benefit of upside with the shareholders but does not bear the burden of the downside. For example, if the warrant has a fixed price of $100 per share and the company performs well, pushing the stock price to $200 per share, the warrant holder will exercise her purchase right and realize a gain from the increase in value. On the other hand, if the company performs poorly and the share price falls to $50, the warrant holder will simply decline to exercise the purchase right and thereby avoid the loss borne by the shareholders.

Since warrants have such an attractive investment profile, why are suppliers willing to give them to Amazon? Obviously, they think the opportunity to do business with Amazon is worth the dilution to future returns. Amazon’s negotiating leverage is an example of the perils of customer concentration.

When we value family businesses, we focus on three things: expected cash flow, risk & growth prospects. Large customer concentrations can boost expected cash flows, but also increase the risk of those cash flows. All else equal, higher risk translates into a lower valuation multiple. For many clients, this is a “high class” problem: would you rather have a business with $100 of EBITDA and a 6x multiple, or $200 of EBITDA and a 5x multiple? The challenge for family business directors is to identify strategies for mitigating the risks of customer concentration while retaining the business of the large customer.

We have observed two strategies that have worked well for our clients seeking to mitigate customer concentration risk.

1. The first, and probably most obvious, is to leverage what you learn from dealing with the large customer into new business with other customers. Just as the most demanding teacher is probably the one that you learned the most from, the most demanding customer is probably the one to teach you the most about your own business. As we mentioned at the beginning of this post, several clients have confessed to us that, while selling to Wal-Mart was not exactly enjoyable, the challenge of doing so forced them to improve their processes and cost structure. As a result, they were in a better position to secure profitable business from other customers.

Continuing our example, suppose the company leverages its experience with the large customer to capture additional profitable business from other customers and EBITDA grows from $200 to $300 (a 50% increase). As the customer concentration risk recedes in the wake of a more diversified customer base, the valuation multiple is restored to 6x, resulting in an 80% increase in value ($1,000 to $1,800).

2. The second, and more difficult strategy, is to rebalance the negotiating leverage in the supplier/customer relationship. Does your customer have leverage because they can “push” your product through to the end user? This is how most large customer concentrations start. But some of our clients have been able to take back some of that leverage by investing effectively in their brand so that the end user “pulls” the product through the customer’s channel. Successful brands are less susceptible to the power of large customers because those customers need the brand as much (or more) than the brand needs them. Strengthening the family business brand to this point is likely the work of decades, not years, but can pay significant dividends in both higher cash flows and higher valuation multiples.

Does your family business have a significant customer concentration that is reducing the valuation multiple? If so, what steps are you and your fellow directors taking to mitigate this risk? Give one of our valuation professionals a call today to discuss how customer concentrations are affecting the value of your family business.