“It’s OK to have all your eggs in one basket as long as you control what happens to that basket.”
– Elon Musk
You just landed the “big fish,” aka customer (yeah), but they now represent 15% of your revenue, (ouch)! We have all been there…. high-fives among the sales team…. big smiley faces on the white boards….and the champagne bottle pops open. You landed the largest account/customer ever! You just made your numbers not only for the quarter, but maybe even for the year. Boy, what a feeling, right!?
In my early days, I did all those things above, probably more than once, but as I matured in my M&A knowledge with a plan for an eventual exit, I also cringed when deals like this landed. Don’t get me wrong, I was happy inside too, but it also meant I needed to fish for either more small fish, or a medium salmon or two at least. Why? I didn’t want any one single customer to keep me up at night if they decided to move on, and I didn’t want a potential buyer to have issues with high single “customer concentration”.
What is considered “high” customer concentration?
High customer concentration occurs when a single customer or client accounts for 10% or more of your revenue, or when your largest four to five customers account for 25% or more of your revenue. When a business is overly reliant on a small group of customers or clients, its revenue will be highly sensitive. A 10%-25% revenue drop can cause a business to go from being profitable to dropping below break-even and threaten its ability to survive. But what if you have this customer under a multi-year contract? That helps, but the buyer knows that the customer can leave as soon as the contract terminates or can buy out the contract for other reasons.
A concentrated customer base increases the risk for the owners, everyone who depends on the existence of the business, and for potential purchasers. In particular, how prospective buyers value your business will be commensurate with the risk involved in your cash flow. For a potential purchaser to invest in a business with a concentrated customer base, their rate of return will need to be higher, which translates to a lower value purchase price. In terms of EBITDA (earnings before interest, taxes, depreciation, and amortization) multiples, this can easily shave off multiples if not entirely kill a deal. Learn about COVID-19 EBITDA adjustments.
In the process of selling a company, potential acquirers will do a SWOT analysis (strengths, weaknesses, opportunities and threats) on the company and perform due diligence on the customers and the end-use markets that the company supplies. High customer and end-use concentration will be viewed as a risk factor and will impact the EBITDA multiple that the acquirer will be willing to pay for the company. The higher the perceived risk, the less they will be willing to pay, and the more they will want to defer from cash up-front to an earn-out over a period of time. Learn about 5 tips to getting better earn-out agreements.
A few recent real-life examples
In the last two years, I have seen this issue pop-up three times.
The first deal stalled midway through due diligence because 25% of the top line revenue came from one customer, so the buyer decided to wait until the customer was up for renewal ( in four months ) and see if the customer renewed. The seller (not one of mine) knew he had to renew the contract, but somehow the customer caught wind of the pending sale (my guess through a consultant on the project) and decided to shop the upcoming contract with other providers. In the end, the customer found a better deal somewhere else as the buyer didn’t want to lower their annual subscription fees for the services. And the entire deal went down river…. forever.
The second example was a seller who had 13% of revenue tied up in one customer subscription. During the last week of due diligence, the buyer began customer references. Unfortunately, this large customer was in the middle of the second phase of an implementation project and was raising a few concerns which made the buyer nervous. Instead of moving forward with the deal as outlined in the initial LOI, the buyer decided to change the terms and push out 20% of the initial proceeds into an earnout to coincide with the renewal of this customer. Fortunately, the renewal did happen, and the seller received his earnout, but it could have been avoided completely if the customer concentration wasn’t so high.
Finally, there is the seller whose largest client is… well, think Prime, Cloud, etc… I think you can guess who. More than 75% of their revenue came from this one customer annually, even though the seller has multiple contracts lasting more than a couple of years with this customer. I mean, who wouldn’t want this hypothetical customer, right? Afterall, their valuations are in the billions, so they are certainly not going to go bankrupt anytime soon! Not to mention the seller has numerous multi-year contracts, and they have had a strong vendor relationship for more than 10 years. But buyer after prospective buyer all backed out when they saw the high customer concentration around this one account.
Why? Even with the financial strength of this customer? Whether it is a strategic buyer, or a PEG making the acquisition, there is usually some level of debt involved, and most lenders cannot check the box to approve a transaction with this high level of customer concentration no matter who it is.
In the first two instances, these customer concentrations probably can be fixed over time by expanding and diversifying the customer base to the extent possible before beginning a transaction. Even then it may still have an affect on the EBITDA multiples.
In the last instance, it really cannot be fixed, and the seller will need to look for a buyer who isn’t concerned at the high level of concentration and is able to structure the deal without any debt. Even so, it will affect the valuation of the company.
However, let’s not stop here and assume there are NOT other forms of concentration that can affect valuation.
Other forms of concentration
In our next post we will discuss 4 other types of concentration that can negatively impact the valuation of your business. Stay tuned to learn more about:
- Vendor Concentration
- Geographic Concentration
- Industry Concentration
- Employee Concentration
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