How much customer concentration is too much? Less than you might think! For a searcher, the best-laid plans to acquire a business with low customer and market concentration, recurring revenues, healthy margins, and industry tail winds can be easily tossed out the window when you are faced with a business owner who seems very motivated to sell their business and legacy to you!
In my mind, the most important of the “search fundamentals” is customer concentration. If only a few customers dominate your revenue, it can have far-reaching impact on the short-term survival of your business. Many searchers have purchased businesses with minimal recurring revenue, lower-than-average margins, and less-than-stellar profitability without severe consequences. But getting on the wrong side of customer concentration can be fatal.
Unlike a PE firm, you won’t have a portfolio of businesses and cannot afford to “wait it out” when your significant customer dramatically cuts their order pattern, gives you an ultimatum to reduce your prices, sucks up a significant amount of your management attention or files for bankruptcy.
Levels of customer concentration
High customer concentration means “never letting one customer represent more than 10% of sales or have five customers comprise greater than 25% “. Yes, you could stretch this to 15% and 30%, but be mindful that you are not running a startup where it is expected that you have multiple rough quarters, instead, you have a bank ready to take the keys from you when you have 3 bad months!
More importantly, this is probably your first “operating” experience, which is hard enough to master without layering on top of it having to do a turnaround for which you have had no practice or direct exposure.
It takes a lot of discipline to build a company with this level of diversity. Most SME’s struggle to establish a sales force and a marketing function to expand beyond their initial customer base. For many business owners, responding to your biggest customer to provide more revenue opportunity feels like a no-brainer. It is more difficult to find 5 additional customers than it is to focus on just a chosen few. There is an inherent bias to “treat the customer right” and employees often get so close to their existing customers that they almost feel disloyal spending time elsewhere.
This is where your leadership comes in
When growing a business, it may seem better to have a single $5M customer than 5, $1M customers. However, it is often easier to extract higher prices from smaller customer segments than a few large customers. Too often owners rationalize lower margins for a high-volume opportunity in a wrong-headed bid to “cover overhead”. The result is few customers with increasing leverage and lower overall profitability – a worrisome proposition. Best to find those 5, $1M revenue opportunities.
Some enlightened customers may be reducing their supplier base and recognizing the value of the “partners” in providing more than just a service or product. This can be a double-edged sword. While being a “partner” exposes your business to more and larger business opportunities, many industries have businesses with reputations of being very challenging and “controlling” of their supplier base – and attendant lower margins and profitability and reduced vendor loyalty. Walmart and Dell Computer come to mind as examples in the B2B arena. Caveat emptor!
Other concentration risks
Beyond customers, too narrow of a focus on a single market is a yellow flag. Searchers who are running businesses serving the Oil and Gas industry are subject to the vagaries of international commodity markets. In one case, Patrick Dickenson of Ninth Street Capital Partners followed an upward cycle in drilling pipe and was successfully able to exit before the peak. Others have missed the peak in their global commodity markets and may experience a decade-long struggle to return to prior levels of income and revenue. Often not what they had bargained for.
Similar boom and bust cycles impact automotive, home construction, mining, airlines and even telecom. While the EBITDA multiples in these industries may seem attractive, neither your investors nor lenders have the patience to wait for a recovery and would rather deploy their funds elsewhere.
Ironically, during a widespread recession, where all boats are sinking, it may be easier to navigate through these financial shoals. The EBITDA multiple “penalty” for these businesses does not generally translate into “over raising” and having a significant “cash cushion” to insure against a few critical customers hitting bad times.
Other concentration risks matter as well. Dependency upon a small number of suppliers may raise risk levels depending on your importance to them- often difficult to discover during due diligence. Others risks include regional/geographic concentration with cyclical swings greater than 20%. Even a high dependency on an ethnic-specific workforce, or specific skill-sets may increase risks.
Customer concentration risks can play out badly. When a large customer runs into trouble or decides to purchase from a competitor, the decrease in your company’s revenues hurts cash flow and may also be a precursor to margin erosion as competition scrambles to hold on to market share and you desperately hold on to the business with price concessions.
As a new CEO, you may fail to move quickly enough to match costs with decreased revenues, hoping for better times or replacement revenue to come in the door. While working capital needs will fall with decreased revenue, overall margin dollars will have an immediate impact on free cash flow. Of course, the same scenario happens to sellers also!
Missing your debt covenants is generally the first tripwire that trigger the bank to protect their collateral and interest/principal payments. Getting assigned to the bank’s workout group means a much closer examination of your performance, faster sweeps of cash by the bank and a review of your personal guarantee, if you had one. Banks become reluctant to loan against Accounts Receivable when a single customer dominates your revenue. You may spend more time managing the bank and your daily cash flow than growing the business, as your company “circles around the edge of the drain”.
In current environment of easy debt access, low interest rates and SBA backed financing pressing all lenders to be more “competitive”. It can be easy to succumb to over-leveraging if you are on the edge of the concentration guidelines.
Mitigating the risk factors
There are some things a CEO can do to alleviate concentration risks. Examine the buying influences at the customer to determine if there is centralized purchasing or multiple purchasing points that lower the possibility of a single point of influence. Best to stay below the radar screen and avoid the natural tendency to “sell up the chain”, potentially raising your visibility and vulnerability. This also applies to separate model platforms in automotive, or product lines at an OEM hardware supplier like CISCO, or a large hospital with geographic buying autonomy.
Long term contracts may also help mitigate risk, especially with staggered expiration dates. However, for many SME’s these are difficult to obtain. A CEO who is trying to maximize the value of their business that finds itself with high levels of concentration will be incentivized to establish contractual commitments.
On the buy side, most sellers understand that there will be a discount for high levels of concentration, however, a new seller may not be willing to hear this from just you. Their accountant or M&A advisor may come in handy in these situations. In any case, you want enough “headroom” in the amount of cash you raise for your purchase to suffer though the loss of a significant customers during your ownership period. One searcher after suffering through a protracted global industry “slump” reflected that “the purchase price should have much lower”. These businesses may be a better option for a strategic buyer who is looking to reduce their own customer concentration levels.
While it may be worth the effort to tie seller payments to future revenue from the established customer base, most sellers won’t agree to this. Too often, they are unwilling to leave the risk of managing their old customers once they relinquish control to a new owner.
Mitigating risk through customer diversification is the key to a searchers “holding on” to their business. Having your eggs in one basket may seem efficient but will leave you vulnerable in a significant downturn. Having more baskets and more eggs is better.
Don’t be tempted to convince yourself that you can fix high customer concentration quickly, especially in your first acquisition. Finding new customers, extracting them from competition and holding on to them takes much longer than searchers think. Best to pass on these “flawed” opportunities at the outset.
Feel free to share some of your own best practices or experiences in dealing with these issues in the blog comments. I encourage comments and dialog, allowing all to learn from both my views and the views of others – a virtuous learning cycle. Jump right in! I regularly update individual blog posts, add to the Reference section and Search tips, so visit the www.jimsteinsharpe.com website regularly.
I want to thank you for writing on this critical topic. High concentration levels in all its forms are one of the business characteristics that a first time acquirer may discount too quickly. If you have to hold a prayer session before a major client contract renewal — you probably bought the wrong company.
Rich, Thanks for reinforcing the importance of finding owners where their “major clients” are not fatal to the business if they do not renew their contract.
This is very helpful Jim, thanks for publishing.
I am a current searcher focusing on B2B service business within the IT space and customer concentration is a very key part of the business evaluation/valuation and diligence. And you’re right, as a buyer its essential to focus on this but sellers unfortunately will discount the risk that this holds and how it changes a buyers willingness to pay.
How have you seen seller financing, or maybe earn-outs, being tied to existing customer base staying with company after the acquisition (maybe for a set period of time)?
David, I appreciate you pushing this dialog along. Indeed, sellers don’t see the same risk, after-all, they have been living with the concentration for many years without a problem. They may need one of their professional advisors to point out the negative impact on valuation. Earn-outs and contractual revenue alignment techniques tend to back-fire since the seller really is reluctant or not around to intervene once they move away from the business. Also, since it takes so long to “fix” concentration by broadening the customer base, the risk of losing a customer has a very long tail.
I have seen one search where bank debt, seller notes and equity yielded a full 1.5 turns of “extra cash” at closing to reduce some of the risk associated with a particularly large customer. Best to pass on these situations, rather than seek out risk mitigation…there should be plenty of other opportunities in your pipeline.