Mitigating Customer Concentration Risk

We recently reviewed a business that was for sale - a niche manufacturer in Australia.

On face value, the business looked wonderful. Very strong profit margins and stable revenues. The current owners have operated it for over 25 years.

The red herring was the customer mix - 70%+ of its revenue was derived from 1 single customer. 

It’s a good business, but not a great one - which is why it failed our initial screening.

At Arbor Permanent Owners, one of the attributes we look for in a Great business is minimal customer concentration - meaning any one customer should not constitute more than 15% of sales.

In the Serial Acquirer model, diversification of cash flows over the long-term is a cornerstone of the strategy. Diversification means there is not one single point of failure.  It's a safeguard against volatility - the adverse performance of one business doesn't harm an entire portfolio. 

An overlooked counterpart to diversification is understanding customer concentration risk within the underlying businesses. This can be significant risk and deserves a closer look.

Unpacking Customer Concentration Risk

Customer concentration risk is the threat posed to a company's financial health by its reliance on a customer for a significant portion of its revenue. 

This issue is pretty common - from software companies firms relying heavily on a few enterprise contracts, to niche manufacturers with a limited client base. It’s mostly prevalent in B2B models.

The risk to the business is if one or more of these key customers were to reduce their orders, switch to a competitor, or go out of business, the financial impact on the company could be severe.

A key procedure in our due diligence process is assessing how dependent the business is on any single customer. If more than 15% of total revenue is generated from any one customer, we need to have conviction that the business is still resilient without it.

Whilst customer concentration is a big risk, it’s not always a deal breaker. 

Here are some examples where we may make exceptions to our rule:

• Contracted Revenue - the revenue is secured via long-term contracts

• Bolt-on acquisitions - cross selling complementary products and services offered in your existing portfolio can spread this risk. 

• Deal structure - structuring an earn-out / contingent payment on a key customer renewing their contract, ensuring future revenue is maintained.

About Arbor Permanent Owners

Arbor Permanent Owners is a Serial Acquirer holding company that acquires and invests in exceptional, private businesses, deliberately built for long-term success. Our goal is to be the long-term custodian and permanent home of Great Australian Small and Medium Enterprises (SMMEs).

We are actively looking for businesses with the following characteristics:

• Business Model: B2B industrials: manufacturing and mission critical services

• Business Size: $3 to $6 Million of EBITDA

• Business Profile: Sticky B2B customer base

• Business HQ: Australia

Whether you’re a business owner interested in working with us, or an intermediary with a deal to share, I’d love to hear from you. Please email us at [email protected]