How important is customer concentration?

searcher profile

June 21, 2023

by a searcher from INSEAD in New York, NY, USA

I've come across a deal that looks great in all other ways (healthy EBITDA margin, growing industry, fair multiple, low capital intensity, etc.), however one major red flag is that 3 customers make up 95% of the company's revenue.

The seller has assured me that the reason for this is that these customers fill their capacity and that they have requests from other customers they can't serve but stick with these 3 customers out of loyalty as they have been with the business for many years. He also mentioned that these customers have close relationships with the managers who will stay on for at least two more years.

Has anyone successfully bought a business with such high customer concentration or would this be too risky? Any thoughts on how to mitigate or further due diligence the risk?

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commentor profile
Reply by a searcher
from Rutgers in New York, NY, USA
Agree with an earnout structure contingent on customers maintaining their revenue. Would also include an earnout contingency if any of the managers leave ahead of the two years he promises. This will give you 2 years to build more customer diversity, but he mentioned not increasing the customer base out of loyalty to current customers, so will expanding your set of customers hurt your relationships with existing customers? If so, you might be stuck with the customer concentration for foreseeable future, which should also lower valuation since less growth potential.

From a risk perspective, consider if you lost 1-2 of the customers, would your liabilities still be paid (ie, are most of the costs variable with revenue?)

From a revenue perspective, if you lost customers, how long would it take to replace the revenue stream? Would you be able to charge similar prices or would you need to lower prices to attract new customers?

The valuation of the business should be tied to the potential, but also the risk. You don't want to pay $X for a company that will be valued significantly less in 2 years. So would say its fair to negotiate down for the risk you’re taking on. With that in mind, would also check stability (ratings, credit, size) of these customers. The risk is not only that they leave and go to your competitor, but also if they can no longer make payments or go out if business. Then ~30% of the business is gone. Would form your view on the valuation of the business before negotiating with him. The likelihood of each risk should come into play.
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Reply by a lender
from University of Missouri in St. Louis, MO, USA
Customer concentration isn't a deal killer to getting financing. However, the ability to get a loan isn't the same as Should you get the loan....by this I mean there are lenders that will finance this but if one or two of the customers exit or pullback, can you still survive? In your case, is the 95% equally distributed or is one more dominant? Also, see if you can determine the Gross profit margin concentration v. revenue concentration. That might not be easy to establish but if one company has 30% of revenue but 50% of gross profit, that changes the dynamic. The approach I would take in underwriting is that one of these customers will exit immediately after the sale. If the loan structure still works at that point, then you should be ok. If one customer exiting the business kills the deal then it is not a deal you should do, at least in my opinion. Either 100% seller financing/earn- outs, or large and contingent seller notes would be the way to go. Also, keep in mind when you have concentration the customer doesn't have to stop working with you altogether to be an issue. They could just delay or decrease orders based on other factors outside of your relationship (a real world example was a warehouse fire that shut down a client of a borrower of mine and stopped orders for almost 6 months). This is equally as likely as them existing the relationship but could have an equally catastrophic result.
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