The Propensity to Pay

Between 2023 and 2026, my team and I looked at roughly 200 businesses. Most of them were good companies run by people who had spent decades building them. A much smaller number were companies a control investor could responsibly put debt on, own for 5 years and hand to the next owner in better shape than he found them. The gap between those 2 groups had surprisingly little to do with size, growth rate or the quality of the management presentation.

It came down to 2 lines. The first was gross margin, or a credible path to a better one. The second was whether the revenue had to be sold again, from scratch, every year. Those 2 lines ended more looks early than every other diligence question combined, and they are worth understanding for anyone on either side of the table: the owner thinking about a sale, the banker deciding which teaser to write next, and the capital partner deciding which sponsor to back.

The Customer's Vote

Gross margin is usually read as an accounting output, and it also carries the best behavioral data in the file. It tells you how much a customer is willing to pay above what it costs to make the thing, which makes it the cleanest single measure of a customer's propensity to pay. A customer who accepts a 45% gross margin year after year is telling you something about the product that no customer reference call will say out loud.

Usually the message is some combination of a few things. The part is specified into the customer's own product, so changing suppliers means requalifying. The product is a small line on the customer's cost structure and a large one on their risk register, so nobody in purchasing gets promoted for saving 3% on it, and someone could lose their job if the switch goes wrong. The supplier shows up when the line goes down. When those conditions hold, price becomes a conversation between partners. When they do not, price becomes the only conversation, and it happens every time a purchasing manager needs a win.

The mechanics matter most when costs move. Take 2 businesses with 40m USD of revenue and 5m USD of EBITDA each. The first runs a 45% gross margin with materials at 30% of revenue. The second runs 22%, with materials at 50% of revenue. A 10% increase in material costs takes 1.2m USD out of the first company and 2m USD out of the second, which is 24% of EBITDA against 40%. To recover it, the first company needs roughly a 3% price increase from customers who have already shown they will pay for the product. The second needs 5% from customers who chose it on price. A 3% increase to customers who already value the product is a normal annual conversation. A 5% increase to customers who picked you on price usually sends the work back out to bid.

Or the Ability to Get There

The qualifier matters as much as the number, and it is where an operator reads a business differently from a pure financial buyer. A low gross margin comes in 2 kinds. The structural kind lives in the market: commodity inputs passed through at cost, a customer who owns the specification and rebids it annually, a product any competent shop can make. No amount of work on the floor changes that, because the margin is set by the customer.

Inside the plant lives the other kind. Scrap running at 6% when it should run at 2%. Changeovers that eat a shift. Overtime paying for a schedule nobody trusts. Expedited freight covering for a planning process that does not exist. A business at 28% gross margin whose peers run at 38% for these reasons is one of the best things a buyer who knows how to run a plant can find, because the customers have already proven they will pay. The gap between what the customer pays and what the product costs to make is the improvement plan.

Telling the 2 apart is the work. The market and revenue characteristics come first: who buys, why they stay, how concentrated they are, what happens to price when volume moves. If those say the customer values the product, the plant assessment that follows tells you how much of the margin gap is waiting on the floor. If they do not, the plant assessment is answering a question that no longer matters.

Gross margin is the customer's vote on what you are worth, and they cast it on every invoice.

Paul W. Swaney III

The Book That Starts at Zero

The red flag that ended the most looks early was a business that has to sell its whole book every year. Project revenue, in its many forms, is a company whose backlog is its only visibility and whose January starts at zero. A great year in that model says the sales engine had a great year. It says much less about next year.

These can be wonderful businesses to own outright. The founder is often the best salesperson in the building, the cash is real, and a strong owner can run one for decades. The trouble starts when you try to put leverage on it and hold it for 5 years. A lender sizes debt against earnings it believes will repeat, and project earnings repeat only if the next 12 months of wins show up on schedule. The multiple reflects the same doubt. Underneath the financing sits a harder operating problem: when the founder steps back, the book walks out with him, because the relationships that won every project were his.

Contrast that with revenue that comes back on its own. Consumables that reorder. Parts specified into a platform that runs for 10 years. Service contracts that renew unless someone actively cancels them. Replacement cycles driven by wear. None of those require the company to be won again from scratch, and every one of them lets an operator spend the hold improving the business instead of refilling it.

The Same Question Twice

Looked at closely, the 2 lines ask the same question. A high gross margin and a recurring book are both evidence that the customer comes back and pays without being won over again. Project businesses tend to carry thinner margins for exactly that reason: every job is bid, every bid is a price conversation, and the customer's propensity to pay gets reset to whatever the lowest credible competitor offered that month. The rare business that combines a strong margin with revenue that renews itself is the one every buyer in the market is chasing, and it rarely needs a long process to find a home.

Before the Teaser Goes Out

For an owner thinking about a sale, the most useful preparation is a clear account of why customers pay what they pay and why they come back. Pull gross margin by customer and by product line for 3 years. Show which revenue reorders without a salesperson involved and which had to be won. If the margin is lower than it should be because of scrap, changeovers or freight, say so and show the numbers, because a buyer who can fix that will pay for the opportunity, and a buyer who cannot will discount it either way.

Bankers can read the same 2 lines as a forecast of which buyers will show up and how hard they will lean in. A business with a strong margin and a renewing book can run a broad process. A project business with thin margins will find a narrower group of buyers, usually strategics who can fold the book into their own sales engine, and the teaser should be written for them.

The capital partner sitting across from a sponsor has the simplest test of all. Ask him to explain the deal's gross margin in terms of customer behavior, then ask what share of next year's revenue already exists today. A sponsor who answers both without opening his laptop has done the work.

Across those 200 looks, the businesses I would still back today shared a margin that proved the customer's propensity to pay, or a gap an operator could close. The ones that ended earliest made us win the customer again every January. Price can be negotiated. Propensity to pay cannot.

I am the founder of Swaney Group Capital, a fundless sponsor focused in the lower middle market. LeverUp® is published weekly. More if I have something else to say.