January 21, 2022

How to Address Customer Concentration with Investors

John Douglas
Senior Manager

Having a clear understanding of the makeup of your customer base is important to know exactly where your revenue is coming from. Many startups tend to have one large customer that can account for 20-30%+ of its revenue base; this is known as customer concentration. While you may be proud to have landed and service this large customer (as you should be), it can cause a headache when fundraising and/or selling your business.

As a founder, you must be prepared to build a case to de-risk the significance of that customer on the business in order to get a deal done and/or support a higher valuation of the business. (More on this below).

Risks Associated with Customer Concentration

For investors, customer concentration can be a primary initial filter when they are sourcing deals. They have to feel comfortable, upon execution of a deal, that the large customer’s relationship has longevity. There are numerous risks associated with customer concentration including:

  • The obvious—if the customer switches to a competitor, you’ve lost a significant chunk of your revenue.
  • The large customer can exercise its influence through pricing or other contract terms as it becomes aware that it is vital to the health of your company.
  • The customer may comprise a majority of your costs structure and human capital, further amplifying the risk of a cost structure too dependent on the revenue of that customer.
  • There is collateral damage to your company’s cash flow if your largest customer experiences financial difficulties.

As a Strategic Finance Senior Manager here at KPI Sense, I get asked quite a bit about how to present customer concentration to concerned investors. With these concerns in mind, I’ve come up with a list of considerations to help and prove to investors that not only are you aware of these risks, but also are taking proactive steps to mitigate them.

Operational Considerations to Mitigate Customer Concentration Risk

  1. Sign a long-term contract with your major customer. This can be paired with a renewal and/or add-on of existing services.
  2. Demonstrate how vital the product is to the customer.
  3. Communicate why there are high switching costs to a competitor including: long implementation times, highly customized offerings, years of service, competitor pitfalls, etc.
  4. Prepare a summary of relationships at the organization to portray it hinges on a number of individuals vs. a single contact.
  5. Prior to selling or fundraising, generate sales pipeline of customers of similar size to provide evidence that the customer concentration will be alleviated in the near-term.
  6. Consider an acquisition of a smaller competitor in order to diversify the customer base.

Deal Structure Considerations

  1. Making funds contingent on customer retention (i.e. earn-outs).
  2. Ensuring the investor that the main contact involved will stay to help transition the relationship through employment contracts or other incentives.

It may be prudent, if customer concentration is a quality of your current business, to have a small write up in your data room defending why the current customer concentration risk is not an issue.

If you’re not sure where to start, we can help! We work with companies every day to gather and present their financial story to investors in the best light possible. We’ve helped startups formulate and answer numerous due diligence questions since our inception and we can help you as you prepare for significant financial events in your future. Drop us a note here!

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