Don't Let Customer Concentration Derail a Deal
It can be risky to rely too much on one customer, as most business owners know. So, it should not come as a surprise that excessive customer concentration can be a significant issue for companies involved in M&A transactions.
Despite being conscious of customer concentration, however, few M&A participants know how to navigate the situation.
Both buyers and sellers should be aware of customer concentration, familiar with how their counterparty views the issue, and prepared to take action to mitigate the risk that a deal gets derailed.
An otherwise promising transaction can be thrown off course because a seller relies too heavily on one customer or a small handful of customers. That said, there are practical ways to acknowledge and address customer concentration.
How to Think About Customer Concentration
Defining customer concentration is far from an exact science. Acceptable levels of customer concentration vary by industry, business size, and other factors. As a rule of thumb, a company’s single largest customer should represent no more than 10% of revenues.
More broadly, we can say that customer concentration is simply the overreliance on one or more clients for a disproportionate share of overall revenues, profit, or resources committed to servicing the business.
Parties to an M&A transaction should avoid customer concentration for the same reasons that an individual company should: their larger customers will have an outsized negative impact on their operations if those customers choose to take their business elsewhere, close up shop, or try to throw their weight around in negotiating terms and pricing.
To be clear, no two situations are alike. Customer concentration may be less concerning for buyers that are seeking economies of scale by purchasing a competitor, especially in an industry with a limited number of potential customers. Strategic buyers can absorb customer concentration better, but the seller’s book of business should be attractive enough to justify the risk.
As we work through due diligence with buyers or sellers, evaluating customer concentration is standard procedure.
Questions asked of sellers often include:
How “sticky” are your larger customers?
Do any customer relationships depend on current ownership being in place?
After the sale is completed, do you expect to renew contracts that are in place?
How are new customers procured?
Are you taking any steps to diversify your customer base, such as by implementing a business development program or upselling to smaller customers?
Questions asked of buyers often include:
Is the seller doing anything to mitigate customer concentration?
Are you de-risking customer concentration through contracts or other methods?
Do the seller’s largest customers have loyalty to the seller that could fail to carry over when new ownership is in place?
How to Mitigate Customer Concentration
When serving as a sell side advisor, we first gauge the viability of a sale by analyzing customer concentration. Sometimes a company is better off waiting until it successfully diversifies its customer base before going to market.
If customer concentration is a concern but not a deal killer, safeguards can be put in place.
While a buyer may seek a discounted purchase price to account for customer concentration, earnouts are another way to move ahead with a deal while alleviating risk. By attaching some portion of consideration to post-closing performance metrics, a buyer can be protected from any larger customers jumping ship after the deal closes.
Every deal involves risk mitigation, and excessive customer concentration should always be part of the conversation.
As an advisor to both buyers and sellers, Copper Run helps navigate the complexities of customer concentration to ensure it does not impede a successful transaction. If you are unsure how customer concentration may impact your business going forward, contact Copper Run for more information and guidance.
Matthew Roberts is Director at Copper Run. He specializes in the business services, distribution, and manufacturing sectors.