Impact of the Customer Concentration for a business when doing due diligence for the purchase of a business

Customer Concentration is a very big deal for the owner of a business, which also applies to a buyer considering purchasing that business.  How does this impact the Due Diligence process and the decision to buy the business when investigating the potential of a business?

Because there is an inevitable attrition or defection of customers when a new buyer takes over, it’s important to analyze the customer concentration.  Naturally, upon change of ownership some customers will revisit relationships with other vendors and may take their business elsewhere, even if there are no hiccups during the ownership transition period.  If the customer base of the business being purchased is well diversified, then there is some built in protection, since a few customer defections might not hurt so much.  But, there is much more to it.

More than just making sure that the customer base is broad and diverse, is analyzing the nature of customer base along a few key factors.  Two of which are discussed below.

The first key factor worth considering is the profitability of each customer.  Some customers might offer the business a higher profit margin due to the products/services they purchase.  A varying profit can be the result of many factors.  Some of the factors are the logistical costs of delivering the product/service to the customer, the payment terms offered to the customer, follow up customer service costs for the customer, requiring additional labor to service or supply the customer and more.  Sometimes these factors can lead to a larger customer of the business not end up being worth the trouble to service due to the ultimate profit margins not being high enough.  Don’t assume the current ownership has assessed and analyzed the profitability of each customer.  Often times the owners of a business lose track of profit margins since they are focused more on customer retention and the status quo.

Another key factor is opportunity cost.  Following the 80/20 rule, there might be a small portion of the customer base that is draining a majority of company resources.  Thus, there might be reason to alter terms to make those customers worth their while, such as by raising prices, or changing payment terms.  If the customers that drain resources leave, then those resources are better utilized to service the existing customers and new customers that come in.  If they accept increased prices or altered payment terms, then maybe they become worthwhile.

The way to investigate the quality of the customer base is to request data on the customers during the Due Diligence period or earlier if possible.  Things to request include but are not limited to the following:  a list of revenues by customers, Accounts Receivable aging reports, copies of contracts or agreements with the customers, customer order history, returns and allowances report, and more.

What this all adds up to, is that even if the historical profit of the business justifies the business valuation and purchase price of the business, other factors that come out during due diligence such as the quality of the customer base can point to passing on the business for sale.

You can also contact our Client Care Manager Sonia Chhabra by telephone at (888) 926-9193 or by email cs@justelementary.com for more information on how Just Elementary, Inc., can assist you with the Questions to ask when buying a business.

Bear in mind that this is not a complete list of questions to ask when buying a business.  Also, not all of these questions will apply to each business that you will be investigating.  Always consult with a qualified legal professional for legal advice.  This article is not intended to be interpreted as legal advice.

For further reading and viewing you can click the Nuts & Bolts of Due Diligence article on the website.