Business Buyers Will Always Check For This… It Could Be Costly
Blog Series 1 of 6
Author: Mark Mroczkowski
A crucial red flag when evaluating a new acquisition target is a lack of customer diversification. Companies with customer concentration greater than 20% of total sales may pose a significant problem for a buyer. The nature of the relationship between the company and its large customer(s) needs to be thoroughly vetted before finalizing a purchase price and capital structure. The buyer must weigh all the positives and negatives discussed below.
Positives
Having one or several large customers can be beneficial with the right circumstances. If a company has a patented product integral to its customer’s success, there is a lesser risk of losing that customer. A company and customer could also have a special relationship between principals that would be difficult for competitors to usurp. Most importantly, if long-term non-cancellable contracts are in place, there is generally a lower turnover risk.
Risks
Unfortunately, the risks surrounding customer concentration usually far outweigh the benefits. Typically, any loss of business from a major customer will be magnified. A customer that accounts for 20% of sales may account for 30% or more of profitability due to overhead absorption and production efficiencies.
Suppose the company’s products are commoditized or have limited differentiation from its competition. In that case, a change in procurement agent or ownership of the customer could drastically change its purchasing levels. The new procurement agent may not like the salesperson or has a better relationship with a competitor. When a new owner steps in, the customer may want to re-bid all vendors, and a competitor with a lower price point could prevail.
The strength and position of the customer also will impact the company. If the customer’s business slows down, so will its purchases. Business loss from a large customer is likely to impact profit margins more than losing business from smaller customers.
If the company’s product or service is re-engineered or becomes obsolete because of changing times or technology, the company’s.earnings will suffer greatly.
For potential acquirers, customer concentration is one of the critical filters when processing potential acquisitions. Buyers typically won’t pursue any deal with customer concentration greater than 20% unless it displays one or more of the positive aspects listed above. Even so, any offer made for a company with customer concentration will usually come with an earn-out predicated on the future profitability of the largest customer(s).