Customer Concentration Risk in M&A: How to Measure and Price It

What customer concentration risk is, and why it matters

Customer concentration is the share of a business's revenue — or better, its gross profit — that comes from its largest customers. Concentration risk is what happens to the earnings, and therefore to the price paid for them, if one of those customers reduces its spend, renegotiates or leaves. A business earning £1m from twenty customers of similar size and one earning £1m of which £400k comes from a single account have the same EBITDA and are not worth the same amount. The second has an earnings figure that depends on decisions made in a boardroom the buyer does not control.

It matters more in an acquisition than in running the business, because the buyer pays a multiple of earnings up front for a stream the customer can end. The seller has lived with the exposure for years and has usually managed it well; the buyer inherits the exposure without the relationship that managed it.

How to measure it

A single percentage is where the conversation starts and should not be where it ends. Measure the exposure in several ways.

• The largest customer's share of revenue, and separately of gross profit. A large customer on thin margin is less of the earnings than its revenue share suggests; a large customer on rich margin is more.
• The top five and top ten as a share of the total, which distinguishes a business with one big account from one where every account is big.
• The shape of the distribution. A top-two share of 50% can be two customers at 25% each or one at 45% and one at 5%, and they are not the same risk: losing the largest account costs a quarter of revenue in the first case and nearly half in the second. That is the intuition behind index measures of concentration — a few large shares weigh far more than many small ones — and you do not need the formula to apply it.
• By year, for three years or more. Concentration that is falling as the business wins new accounts is a different fact from concentration that is rising as smaller customers leave.
• By contract. How much of the largest customer's revenue is under a written contract with a term, how much is a framework with no volume commitment, and how much is purchase-order business that could stop next month.
• By end customer. Revenue through a distributor or a main contractor may be concentrated one level up: five distributors serving one end client is one customer.
• By decision-maker. Several sites, divisions or brands of one group are one customer if a single procurement function decides on all of them.

The memorandum will usually give one of these figures and rarely all of them; the first-pass CIM review should record which. The rest are a diligence request — revenue by customer by month for three years is the single most useful schedule in the due diligence checklist.

What makes concentration more or less dangerous

Two businesses with the same top-customer percentage can carry very different risk. The factors that move it:

• Contract length and terms. A three-year contract with a year to run is a known exposure; an evergreen arrangement on thirty days' notice is an unknown one. Volume commitments, minimum orders and exclusivity matter as much as the term.
• Change-of-control clauses. A contract the customer may terminate on a change of ownership turns the acquisition itself into the trigger, and is found by reading the contract, not the memorandum.
• Switching costs. How hard it would be for the customer to move: integrated systems, regulatory approval of the supplier, tooling, qualified processes. High switching costs make a concentrated customer sticky; low ones make it a tender away from leaving.
• Who holds the relationship. If the account is managed by the owner who is selling, the relationship leaves with them. If it is held by a team that stays, it does not.
• The customer's own health and strategy. A customer that is itself in trouble, consolidating suppliers or being acquired can change its spend for reasons unrelated to the target.
• The target's share of the customer's spend. A supplier that is critical to its customer is safer than one that is a small, easily replaced line in the customer's budget.
• Timing against completion. A renewal that falls in the months after completion puts the risk exactly where the buyer is least able to manage it.

How it changes the valuation

Concentration acts on value in two places, and the two should not be confused or double-counted.

The earnings base. The most honest question is what the business earns without the customer — not revenue less the customer's revenue, but EBITDA less the customer's contribution after the costs that would go with it. That figure is the floor case, and a buyer should know it before setting a price. Where the contract runs out inside the forecast period, the projection should carry that uncertainty rather than assume renewal.

The multiple, or the discount rate. Even where the customer is expected to stay, the earnings are riskier than the same earnings spread across many accounts, and buyers pay a lower multiple for riskier earnings. In a discounted cash flow the same judgement appears as a higher discount rate or a probability-weighted forecast. The valuation methods differ in where the adjustment sits; a buyer should make it in one place and know which. Running the five-method valuation on the headline and the floor-case earnings shows how much of the price is one relationship.

How it changes the structure

Where the buyer and the seller disagree about whether the customer will stay, the price can be made to depend on the answer rather than on who argues better.

• An earn-out tied to revenue or gross profit from the account, or from the business as a whole, over the period in which the risk would materialise. The seller is paid for the customer staying; the buyer does not pay for the customer leaving.
• Deferred consideration timed to fall after the renewal date, so that a loss before then can be set against what is still owed, subject to how the set-off is drafted.
• A retention or escrow held against a specific outcome and released on renewal, or after a period of continued trading.
• Vendor involvement after completion, where the relationship is personal: a handover period, a consultancy arrangement, or a retained stake that keeps the seller interested in the account.

Each moves money and risk between the parties and has tax and legal consequences for both, which is where professional advice comes in. The buyer's job is to know what it wants the structure to do before the lawyers draft it.

What diligence should do

• Read the contracts. Term, notice, volume, exclusivity, pricing and change-of-control, in the signed version and not the summary.
• Speak to the customer. Reference calls, with the seller's agreement on timing and scope, are the only way to learn how the customer sees the relationship, whether a tender is planned, and who they think they deal with.
• Reconcile the schedule. Revenue by customer by month for three years, tied to the accounts, with credit notes and rebates visible.
• Check the customer. Filed accounts, credit reports, and news of its own acquisition or restructuring.
• Interview the account team. Who manages the relationship day to day, and whether they are staying.

How it reaches the SPA

In concept, the share purchase agreement can protect the buyer against what it knows and cannot against what it fears. Warranties about the contracts — that they are as disclosed, that no notice of termination has been given or threatened, that no dispute exists — give rise to a claim if the statement proves untrue. A specific indemnity can cover a known matter, such as a dispute already in progress. What no warranty can do is compensate the buyer for a customer choosing, after completion and for its own reasons, to leave; that risk is priced or structured, not warranted. The drafting, caps and limits of these protections are legal work and should be taken as such.

How lenders view it

A cash-flow lender is lending against the same earnings the buyer is paying for, and reads concentration the same way with less appetite for the upside. Expect a lender to ask for the customer schedule early, to size the facility on a case that excludes or discounts the largest account, to look for a covenant or reporting requirement on the largest customer's revenue, and to want change-of-control consents before drawdown. Where the concentration is severe the debt available falls, the equity cheque rises and the returns fall with it — a second, quieter way in which concentration lowers the price a buyer can pay.

How TrueValue handles concentration

The CIM Analyzer extracts customer concentration from the memorandum as one of the figures it reads — the largest customer's share of revenue, recorded as not stated when the document does not say — and scores the business against the acquisition mandate, where an unknown is flagged as a gap rather than scored as a miss. A concentration the analysis reads as a risk is listed among the red flags with the figure it was read from, and when the CIM is promoted to a deal the findings become items on the diligence checklist. On the deal, the economics can be saved as a second named scenario on the floor-case EBITDA, giving the maximum price at the hurdle rate with and without the account. And the walk-away can be written down as an invalidation trigger — a critical red flag opening, the modelled IRR falling below the hurdle, the price rising above a ceiling — evaluated against the record by a rule with no model in it, fired once, and cleared only by a person with a note, so that "we would not proceed above this exposure" is a condition on the deal rather than a sentence in a memo.