A crucial red flag when evaluating a new acquisition target is a lack of customer diversification. Companies that have customer concentration greater than 20% may pose a significant problem for a buyer. The nature of the relationship between the company and its large customer(s) need to be fully vetted before finalizing a purchase price and capital structure. The buyer must weigh all the positives and negatives discussed below.
Having one or several large customers can be beneficial with the right circumstances. If a company has a patented product that is integral to the success of its customer, then there is limited 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 risk in turnover.
Unfortunately, the risks surrounding customer concentration usually far outweigh the benefits. Typically, any loss of business from a major customer will be magnified. A 20% customer probably accounts for 30% or more of profitability due to overhead absorption and production efficiencies (i.e., fewer stoppages and setups).
If the product being purchased is commoditized or has limited differentiation to its competition, then a change in purchasing agent or ownership of the customer could drastically change the levels being purchased. The new purchasing agent may not like the sales person, or they may have a better experience with a competitor. If new ownership steps in they 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, they will most likely buy less with its vendors. As mentioned above, any loss of business from a large customer is likely to impact margin more than losing business from smaller customers.
Lastly, if the product or service the company offer is re-engineered or becomes obsolete because of changing times/technology, the company will be impacted significantly to the downside.
At Westshore, customer concentration is one of our key filters when processing potential acquisitions. We 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 come with an earn out predicated on the future profitability of the largest customer(s).