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How to Handle Risky Customer Concentration in an M&A Target

Kay Cruse Strategex | November 21, 2017

We’re often asked what’s the best approach to take if a potential acquisition has a lot of customer concentration?

For starters, it’s important to evaluate the level of concentration.  Normally, the top 25% of a target’s customer list will account for 89% of its profits.  The second tier of 25% will drop precipitously to 7%, followed by the third at 3% and the fourth at only 1%.

We see this reoccurring formula in virtually every company we evaluate in our 80/20 practice. This is a data-driven practice that helps companies analyze the top 20% of customers, who are responsible for 80% of a given company’s revenue (and profitability).

So what if the top 5-10% of customers account for 80% of the revenue?

The biggest fear – which is unfortunately only sometimes realized – is that once a deal closes, the top accounts either exit or make demands for price concessions. The corporate fallout is disastrous, and the road to rebuild revenues is painful.

Our approach to solving this problem is simple.  It’s important to talk to multiple roles within the top customers to determine the critical stability and loyalty at that account.  In one case we provided customer diligence for, the key decision maker remarked in an interview, “There’s nothing I like about them.  As soon as the contract ends, we’re gone.”

Why didn’t the target share that information?  Likely because it would have killed the deal.

What was clear from our deeper dive into diligence was that even though that was the prevailing feeling, the account really wanted the target to succeed – in spite of the acrimonious relationship.  How did we know?  We asked.

The best practices when there’s concentration

  • Talk to multiple touchpoints within the accounts where there’s concentration. 2-4 at a minimum – who hold roles in day-to-day contact, key decision makers and influencers, and purchasing or procurement responsibilities
  • Ask a wide range of questions that can ‘triangulate’ how the relationship is really structured:
    • What are the key criteria for selecting a vendor in the category, and how does the company perform within that criteria – particularly compared to competition?
    • How well does the target company resolve problems? All companies at some point will have a problem-issue.  What’s important is how well they handle it.  We know that achieving a 75%-80% satisfaction rating in problem-resolution will reflect positively on the stickiness of the relationship.
    • Who is the go-to supplier for new projects or programs? If it’s not the target, why not?
    • Importantly in the B2B world, ask how likely would the contact be to recommend the target company to another colleague in their company or industry? The Net Promoter Score (NPS) rating is critical to understanding the likelihood of future commercial success. If the target company claims to have charted their NPS, it’s still important to run a NPS rating exercise during diligence to gain insights into the top customers, along with their rating of the company.  If they have never calculated a Net Promoter Score, this first one will give the acquiring team a benchmark of performance.  We find high performing companies will be in the range of 50-60% or above.  Those with a NPS of 10% or lower are likely losing market share.  NPS often can be correlated to the company’s historic financial performance in revenue growth (or decline).

Why NPS Matters

The Net Promoter Score rating – often referred to simply as ‘NPS’ – is a management tool used to determine a customer’s loyalty to a business. This score is calculated based on an individual’s response to the question ‘How likely are you to recommend the company/product/service to a friend or colleague?’, on a scale of 1 – 10.  

Customers who respond with a 9 or 10 are considered to be Promoters. These individuals are the most likely to exhibit behaviors that are value-creating (making more positive referrals, buying more, remaining customers for longer, etc.) for the company.

Those who respond with a 7 or 8 are referred to as Passives; those who are generally satisfied, but who may be open to other suppliers or solutions.

Lastly, there are those who respond with a 6 or below.  These customers are considered to be Detractors; they are least likely to exhibit value-creating behaviors, and could prove to be a problem for the overall growth of a business.  NPS is calculated by subtracting the percent of detractors from the percent of promoters.  “Passives” are not included in the calculations. Why do we care about NPS?

The statistics are compelling:

  • High NPS rated companies will outpace their industry competitors with 2-3 times faster growth
  • They are also most likely to achieve a price-premium – often by as much as 20-25%. Why?  Customers like to do business with companies who make their lives easier!
  • Customers who rate a company as a “9” or “10” are more profitable – retention is the common denominator. Satisfied customers are more loyal, and will spend more of their share of wallet with companies who make their lives easier.
  • The lifetime value of a promoter (someone providing a 9 or 10 rating) is 2.5 times greater than that of a detractor (some providing a 6 or less score).
  • High NPS-rated companies will more often have stronger cross-selling opportunities: whether new programs or product adjacencies – customers like to do business with companies they see as more of a partner than a vendor.

So, when it comes to customer concentration the opportunity is to not only assess the relationship, but also to dig deeper into understanding the future potential of that relationship.  Forward-looking conversations provide more insights to fuel a strategic plan that will determine whether growth can be realized, or whether growth is stagnant.  If you’re acquiring a company to remain stagnant, then assessing the security of those relationships may be adequate. If you’re acquiring a company to ultimately grow – then look deeper.

Axial is the deal network for the middle market.

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