Recently, we were discussing a company with significant customer concentration and, specifically, the impact of revenue concentration on valuation multiples. Below are a few thoughts from that conversation:
First, to provide some broader picture context (from Bill Gurley’s great article “All Revenue is Not Created Equal: The Keys to the 10X Revenue Club”):
So, why do [buyers] care about this? All things being equal, you would rather have a highly fragmented customer base versus a highly concentrated one. Customers that represent a large percentage of your revenue have “market power” that is likely to result in pricing, feature, or service demands over time. And because of your dependence on said customer, you are likely to be responsive to those requests, which in the long run will negatively impact discounted cash flows. You also have an obvious issue if your top 2-5 customers can organize against you. This will severely limit pricing power. The ideal situation is tons of very small customers who are essentially “price takers” in the market. Google’s AdWords program is a great example.
So, while the most obvious and feared impact of customer concentration is the loss of that large customer and subsequent capital constraint, the further impacts of customer concentration that persist regardless of churn include pricing power, operational demands, and influence on strategy and roadmap that may be at odds with company’s best interest.
In general, we’d probably characterize a business as having little-to-no customer concentration if the largest customers are a maximum of 5%-10% of revenue and would expect to begin to encounter some questions and valuation impact at concentration above that. However, for some industries dominated by large incumbents, that number is often higher, and an analysis of the business is even more dependent on the qualitative factors outlined below.
Now, to get back to the central question “so what is the discount for customer concentration?”
How to view - and value - customer concentration is scenario dependent, even more so than in a standard business valuation exercise. A big factor in my mind (if not the biggest) is the one near the core of our analysis at SSM of almost every business: the value/uniqueness/stickiness/moat of the solution. Some other factors in thinking through customer concentration include:
- Rate of change of customer concentration and context for why the company has the concentration: that is, is this a young company that won a big account early or is it a company that's been around and hasn't found traction outside one big customer, which draws into question the broader applicability of the solution;
- Nature/reputation of customer with whom revenue is concentrated (are they known as a company who encourages and helps emerging companies or do they have a reputation for “sponging” the IP and then building their own? Do they have a reputation for being sharp-elbowed)?
- Growth and churn rates with accounts other than the concentrated customer(s); and
- Contract terms (particularly length and cancellation provisions).
Now, to take a very big SWAG at putting numbers around this… if a business with little-to-no concentration is valued at one amount, the same business in a vacuum with 67% concentration would be valued at half or less of the original amount (and with a much shorter list of potential buyers/investors). In between those, there’s a step function increase/decrease at ~50% concentration (obviously again highly dependent on qualitative factors above). Also, an analysis of a company with ~67% revenue concentration is a very different exercise from that of a non-concentrated company. Finally, I should point out that we can and do try to value separately different streams of revenue from different customers; that is, to apply one risk-adjusted multiple to the non-concentrated revenue and another multiple to the concentrated revenue depending on its growth and risk.
Many companies, particularly bootstrapped companies, are highly concentrated with one or a few customers early on. These are often great companies providing solutions with broad market applicability, but in the early days were either directly born of a single customer’s need or the newco found a forward-thinking sponsor who was willing to be an advocate for an emerging company. While concentration is a net negative on valuation, a benefit of concentration is by necessity and definition: the directness and understanding of customer wants and how the customer uses a company’s solution. This information that is the lifeblood of growing organizations and has served as the bedrock for many great companies. That being said, most investors will proceed cautiously, if at all, and will apply a discount based on the perceived risk.
Let me know what you think.
About SSM Partners. SSM has partnered with talented entrepreneurs for more than 25 years. The growth equity firm invests in rapidly growing companies that have proven and differentiated software, technology, or healthcare business models. Starting with a relationship built on trust, SSM offers its entrepreneur-partners a thorough understanding of the growth company lifecycle and a collaborative approach to building great businesses. Learn more at www.ssmpartners.com.