Customer Concentration: Good or Bad?
The conversation between buyer and seller illustrated in the cartoon is an example from real life and depicts the differing perspectives buyers and sellers often have when a business has a high level of customer concentration. A buyer will normally view customer concentration as a weakness and a risk that needs to be discounted when coming up with a price. A seller will see the presence of large customers as a measure of the company's success and strength. In the article below, we will discuss this subject in more detail.

· Is the glass half-full or half empty?
Customer concentration is a standard subject on every buyer's due diligence checklist. Typically a buyer will want to know what percent of sales and profits the top few customers of a business represent, or some variation on this type of question (under SEC regulations, public companies normally must disclose if they have any customer that accounts for more than 10% of total sales). If there is a high degree of concentration, the buyer will view a deal as more risky, as illustrated in the
"We would like to buy your company, but the high level of customer concentration is a concern to us". "OK. We will cut back on
sales to our top 3 customers".

cartoon. Clearly, as illustrated by the seller's reply in the cartoon, it is better to have some big customers than to not have them at all or to have them but at a lower sales level. Who would walk away from customers like this? A company with a top customer at 30% of total sales is obviously better than a business without this customer and a top line thus reduced by 30%. However, the question the buyer has is this: Is it more risky to buy a business where the top customer is 30% of total sales, or to buy a business, with the same level of sales, and the top customer at only 10% of the total? To this the answer must be that customer concentration increases risk. However, this is not the end of the analysis, but merely the beginning. With high risk comes the potential for high reward. And so, customer concentration is neither good nor bad per se. It depends on the facts of each specific situation. At one extreme, sales to a top customer may have to be discounted almost entirely because of a high degree of uncertainty. At the other extreme, sales to a top customer may be so secure as to be the equivalent of a fixed annuity.

· Questions that typically are asked by buyers when there is a high level of customer concentration

1. What is the sales history with the particular customer? Have they been a top customer a long time, or just recently? Is there a contract with the customer? Clearly a long-term customer normally presents much less of a risk than a customer that only recently began to purchase in large volumes. And a meaningful contract lessens risk.
2. What is the basis of the sale? Is it price-driven? Does it depend on a personal relationship? Or is it based on superior service and/or superior technology? A customer that will switch suppliers for a few cents a pound, or a customer that only buys from a supplier because of a personal relationship with the salesperson is obviously more of a risk than the customer who buys because of unmatched service or technology.
3. What are the "switching" costs? What would it take for the customer to change suppliers? This can be related to the previous questions. If the product sold is a commodity chemical and is fungible with competitive products, it may be virtually cost-free for the customer to switch suppliers. On the other hand, there are many specialty chemicals that can not be replaced without an extended period of testing and trials.
4. Is the customer sole sourcing it's purchases or does it have multiple sources? Related again to the previous questions, if a customer has multiple suppliers for its needs for a particular chemical, this makes for a riskier acquisition compared to the situation where the customer sole sources its needs for a particular chemical from the company for sale.
5. What percent of the customer's cost of sales is represented by the cost of the seller's product? A chemical may represent a small fraction of a customer's costs or alternatively, a chemical in other circumstances may represent a large portion of a customer's costs. The higher the percentage of the customer's costs the higher the risk typically.
6. What are the customer's prospects? Is the seller hitched to a winner or a loser? A company that is financially strong with good growth prospects is obviously better to have as a top customer than one that is weak and in decline.

· Earnouts/holdbacks may be a solution.
A common way to bridge the gap between how much a seller wants and what a buyer is willing to pay for a business with a high degree of customer concentration is the earnout or holdback or some other type of contingent consideration. In order to lessen the risk to a buyer, part of the price would be contingent on meeting some kind of financial goal after the acquisition.

A word about disclosing customer names to a potential buyer and allowing the potential buyer to talk to or meet with top customers.

Buyers will always want to know the names of a seller's top customers. When there is a high level of customer concentration, buyers may also want to talk to or meet with top customers prior to closing the acquisition to get some indication of the prospects of the business going forward. This can be a sensitive subject. Frequently customer names are not given out to a potential buyer until a later stage in due diligence, sometimes only after a binding agreement is reached. The buyer will however normally condition its agreement to close the deal upon a satisfactory evaluation of the top customer or customers. Customer visits are an even more sensitive matter, and again, in some cases, a buyer will want to talk to or meet with the top customer or customers before closing the deal. In these types of situations, such discussions/visits are normally allowed only at the 11th hour, after the purchase agreement and financing is in place, and the buyer has completed all other aspects of due diligence with no other contingencies remaining.