Customer Concentration and What It Does to Price and Terms

A business that depends on one or two customers can still be sold, but the terms will change before the price does. Buyers respond to concentration by shifting risk back to the seller through earnouts, larger seller notes and holdbacks. Owners who understand this in advance can either reduce the concentration or prepare evidence that the revenue is more durable than it looks.

How buyers measure it

Most buyers and lenders begin to pay attention when a single customer exceeds 15 to 20 percent of revenue. Above 30 percent, concentration becomes a central issue in the transaction. They also look at the top five customers together. A company whose five largest accounts represent 70 percent of sales carries a similar risk, spread slightly wider.

Revenue share is only the first measure. A careful buyer asks further questions.

• What share of gross profit does the customer represent? A large account at thin margins matters less than its revenue suggests. A large account at high margins matters more.
• How long has the relationship existed? Fifteen years of steady orders is different from two.
• Is there a contract? If so, what are its term, renewal and termination provisions?
• Who holds the relationship? If it rests on the owner's friendship with one purchasing manager, it may not survive a sale.
• How difficult is it for the customer to switch? Tooling, certifications, integration and location all create friction that protects the supplier.

Why it matters so much

The concern is the consequence of a single loss. A buyer financing an acquisition with debt has fixed payments. If a customer representing 35 percent of revenue leaves in the first year, the company may be unable to service its loan, and the buyer's personal guarantee is called.

Lenders see the same risk. Some will decline a concentrated deal. Others will reduce the loan amount, which requires more equity from the buyer or more financing from the seller.

How deals adjust

Concentration seldom ends a negotiation. It reshapes one. Four mechanisms are common.

A lower multiple. The buyer applies a discount to reflect the risk. This is the least creative response and often the least favorable to the seller.

A larger seller note. The seller finances more of the price, so both parties bear the consequence if the customer leaves.

An earnout or contingent payment. Part of the price is paid only if the key customer's revenue continues at agreed levels for a period after closing. Note that SBA-financed acquisitions do not permit seller earnouts, so this tool is limited to conventionally financed or cash transactions.

A holdback or escrow. A portion of the price is held for twelve to twenty-four months and released if the customer remains.

Sellers often prefer contingent structures to a discount, because they receive full value if the relationship holds. The trade is certainty for upside.

What an owner can do with time

With two or three years before a sale, concentration can be reduced.

1. Grow the rest of the book. Diversification usually comes from adding revenue elsewhere. Reducing a good customer is rarely the right answer.
2. Put the relationship under contract. A multi-year agreement with assignment rights changes how a buyer views the account. Even a simple supply agreement helps.
3. Broaden the points of contact. Introduce the operations manager, the account manager and the estimator to their counterparts. A relationship held by five people on each side is more stable than one held by two.
4. Expand within the customer. Serving multiple divisions, locations or product lines makes the relationship harder to replace.

What an owner can do without time

An owner going to market soon cannot change the numbers but can change how they are understood.

Present the history. Show annual revenue and margin from the customer for as many years as records allow. Stability over a decade is persuasive.

Explain the switching costs. Document approvals, specifications, custom tooling or service requirements that a competitor would need to replicate.

Disclose early. Concentration found in diligence looks like something concealed. Concentration explained in the first conversation looks like a known feature of the business.

Plan the introduction. At the appropriate stage, and under agreed confidentiality terms, a meeting between the buyer and the key customer can resolve more doubt than any document.

Be open to structure. A seller who is confident in the relationship should be willing to tie some of the price to it.

The other concentrations

Buyers apply the same reasoning to other dependencies. A single supplier with no alternative, one salesperson who generates most new business, or one referral source that sends most of the work each raises the same question: what happens if this one relationship ends? The same remedies apply. Document the relationship, broaden it, and disclose it.

The practical view

Concentration is frequently a sign of something done well. A large customer chose the company and stayed. The task in a sale is to demonstrate that the relationship belongs to the business and will continue under a new owner. Where that can be shown, the effect on value is modest. Where it cannot, the seller should expect to share the risk for a period after closing.

Twelve31 Advisors evaluates concentration as part of every confidential valuation and helps owners plan around it before going to market.