Is high customer concentration a deal breaker?

January 26, 2021

by a searcher from University of Witwatersrand in Johannesburg, South Africa

Hey Searchers,

As I review companies I do come across certain businesses that show promising characteristics but they sometimes have a customer concentration issue and I wonder whether this is always a deal-breaker or whether there might still be a good business underneath.

I'll include some examples below and would like to see if anyone has had success in operating a company that may have similar issues but makes up for it in other areas.

Example 1:

We have certain companies in South Africa that have integrated themselves pretty well at our local power utility and their entire order book comes from the power utility. These companies work hand in hand with the utility and develop the technical standards that apply to their particular niche so it makes it difficult for new players to enter their niche and I believe the power utility has a corresponding supplier concentration issue. I'm still not 100% comfortable with this situation but I would like to hear from someone else.

Example 2:

We also have many road freight companies which have a number of key accounts which make up 10-20% of revenue per account. These customers are secured with 3-5 year contracts and in some cases the freight companies are the sole service provider, offering an integrate solution. In this case, I take some solace in the fact that these accounts are on fixed contracts and there is a strong integration element but I have seen transport companies changed almost overnight at my previous employer so I am not sure how secure I feel about acquiring this type of business.

I look forward to seeing how others think about this.

Best regards,

Atish

Reply by a searcher
from University of Illinois at Urbana in Naperville, IL, USA

As a benchmark what I've heard is that banks here in the United States that make SBA 7A loans typically require customer concentration of less than 20% of revenue from any one customer. If you are over that number, it's not that the deal is immediately dead but the bank is going to start looking for high switching costs or sticky services or contractual obligations. Something that helps to establish that it is unlikely that these customers will leave. How high that customer concentration could go before it became a deal buster is pretty dependent on the reasoning for why the customers can or cannot leave. What may be hard to digest is that it can be a great business in the hands of the current seller. It has been stable despite the customer concentration risk. It makes them great money and the seller thinks it is worth a strong premium. But here's the deal that we have to have clarity on. You are going to saddle this business with debt (I am assuming a loan acquisition) and saddle it with you as an inexperienced operator at the very least inexperienced with that specific company and team. So with the debt service coverage that you have, you may not be able to survive a customer departure that the existing seller could ride out. You also have to plan for the j curve, the slump in top line revenue and/or profitability that happens when you, as a less experienced owner, come in and have to get through the learning curve. If you can survive a basic j curve and the loss of your biggest customer on top of that and still have room to maneuver then maybe you can get it done. But your circumstances are different than the sellers and you need to model it. There are other considerations that you need to think through as well. Customer concentration is a risk, and the longer you maintain that risk the more chance that you lose a customer. So you need to think through what it will take for you to grow out of that customer concentration. If it's a more capital intensive business that is fully utilized right now then you have to be clear on what the capital investment looks like to drive growth. You have to make sure that you have the elbow room to do it above and beyond the debt service. If you don't, then you will be stuck with insufficient working capital to invest in growth, and therefore possibly stuck with customer concentration and then you're just waiting for the other shoe to drop. You also have to consider what your cost cutting options are in the event of customer loss. if you lost that much business how much could you mitigate it by cutting employees or unloading assets? And how hard will it be to get those things back if you return to growth?

Reply by an intermediary
from The University of Chicago in Chicago, IL, USA

I have sold many businesses with high concentration (80%, 80%, 2 each at 40%, 25%, etc.) at top valuation and no (or very small) earn-out. Buyer should have a filter at 10%, or sometimes even lower %, not for go/no-go but to trigger deeper analysis. In certain industries you ARE going to have concentration, like auto, utilities, etc. b/c there are just few customers. Few things that one should analyze are a) Is the Target satisfying customer "need" or "want", b) are there competitors to Target?, c) How long has the relationship been? d) What are the barriers to getting the customer business and why? e) If the quality of product/service by the Target is bad, would the customer operation stop, blow up, get a front page news, etc.? I can go on, but hope you get my point that 10% is a "filter for deeper analysis". it should not be a "go/no go gate".
If you can get a discount that is great, but it is not a substitute for concentration risk unless concentration is low. Earn-out is preferred if one can pull it off.

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