Beware of Customer Concentration Risk

One of the biggest risks in M&A is customer concentration risk. It is hard to avoid as a business owner; if a customer is giving you orders, you generally take them! The next thing you know, your customer has 90% of your sales and they own you. We see this a lot in both the PCB and contract manufacturing industries.

The definition of customer concentration changes from buyer to buyer. Some get nervous at 20% or greater than 25%. Others worry if the top three to five customers total more than 50% of sales. Further, the largest customer may be under 10%, but 80% of the customers being in one particular sector also creates sector risk (e.g., the oil and gas industry).

In many cases, most financial buyers—such as private equity firms—will not touch deals that have concentration risk. This eliminates one of the most active parts of the M&A market at the moment. Also, many banks will not finance deals with customer concentration risk, which forces the buyer to put in more cash and reduces ROI, valuation, and terms.

However, strategic buyers may be interested in a business with high customer concentration but may put more of the deal into deferred payments. This is risky because the seller loses control of the customer relationship after closing (i.e., the buyer may lose the customer by changing policies, pricing, etc.).  A buyer may also want the owner to stay after closing for a longer period.

With a larger acquirer, a 50% customer for you might be a 5% customer for them, which represents less risk and customer due diligence. A strategic buyer may want to get a foot in the door of your major customer and think they can sell a lot more to them. In addition, the large customer may be happy that the seller is being acquired by a larger company, which reduces the customer’s supplier risk.

The longer the customer has done business with the company, the more likely something bad will happen. This is a difficult pill for many owners to swallow. Unfortunately, most distressed companies we see had one large customer that evaporated or stopped paying. It is a risk that many owners are comfortable with, but buyers are usually nervous about.

Below are some reasons why buyers and banks may be nervous about customer concentration risk:

1. One phone call and the business can evaporate overnight.
2. Customers may use the sale of the company as an opportunity to look for other suppliers or change policies.
3. Customers may get acquired or have other sources or policies.
4. Customers may be nervous about putting so much business into one supplier.
5. Customers may have a relationship with the owner or another key person, such as a salesperson. The relationship may change or a key employee may take that customer to a competitor once the owner is out of the picture.
6. Customers may become distressed, start paying slowly, or go bankrupt.
7. Customers may move business overseas.

We’ve been involved in PCB deals that had up to 80% customer concentration, and contract manufacturer (CM) deals that had up to 95%. Deals can be completed in these circumstances; however, both valuation and terms usually suffer.

It can be a difficult and time-consuming process, but here are some steps a business can take to mitigate customer concentration risk:

1. Put resources into developing other customers and incentivize the sales team to grow new business. If internal resources are not available, engage outside representatives and distributors.
2. Monitor the diversification efforts and make sure resources are not constantly pulled in to satisfy the top customer.
3. Co-develop products and find opportunities for customers to invest in your business.
4. Maintain gross margin discipline (i.e., no-bid projects that have low profitability).
5. Be sure that the customer has multiple contact points in your company and is not reliant on one relationship.
6. Get long-term contracts. If a customer’s expansion requires you to invest in equipment and/or more employees, try to get something in return, such as cancellation policies or make-or-take provisions.
7. Diversify into other products and services. For a PCB shop, look into handling overseas boards or turn-key assemblies. For CMs, expand into new services for other customers or into new geographical areas.
8. From an early stage in the company, set a limit on the amount of business represented by any one customer and set floors on gross margins.

By working to diversify the customer base, a business owner can make the company less risky, more valuable, and easier to acquire.

Tom Kastner is the president of GP Ventures, an M&A advisory services firm focused on the tech and electronics industries. He is a registered representative of StillPoint Capital, LLC—a Tampa, Florida member of FINRA and SIPC—and securities transactions are conducted through it. StillPoint Capital is not affiliated with GP Ventures.