Customer Base

Customers are a key asset of any business. Buyers consider several aspects of your customer base and metrics when evaluating your business as an acquisition opportunity. These factors can either add a tremendous amount of value to your business or serve to destroy value. 

Customer Base

Consider how diversified your customer base is. Your customer base should consist of not just early adopters but also late adopters. For example, many software companies make fast progress initially as they sell to early adopters willing to take a risk on unproven software, but progress stalls once they’ve exhausted the supply of early adopters. Ideally, your business should have a balance of early adopters, the early majority, the late majority, and a handful of laggards. 

Of course, small innovative companies’ customer bases will consist primarily of early adopters and the early majority. But the more diverse your customer base, the better. Diversity in your customer base signals to the buyer that you’re obtaining strong traction with your customers and that you have a sound product fit.

If you have a business-to-business (B2B) company, seek to establish customer relationships with large, established companies. The more established your customers, the better. If there’s a strong product fit between your customer base and the buyer’s product line, it may be a prudent investment for the buyer to acquire your company solely for the value of your customer base, especially if time and lost opportunity costs are critical factors in your industry.

Customer Concentration

Customer concentration occurs when a small number of customers generate a significant percentage of your business’s revenues. Here are examples of how the amount of customer concentration is often expressed:

  • The top customer generates 57% of the business’s total revenue.
  • The top 3 customers generate 27% of the business’s total revenue.
  • The top 5 customers generate 42% of the business’s total revenue.
  • The top 10 customers generate 3% of the business’s total revenue.

The higher the customer concentration in your business, the more risk this presents to the buyer. On the other hand, the greater your customer diversity, the less risk a buyer will perceive. In extreme circumstances, I’ve encountered businesses that couldn’t be sold due to high levels of customer concentration. 

How much customer concentration will buyers tolerate?

Some buyers will tolerate customer concentration as high as 20% to 30%, but they may expect certain deal-protective measures in the purchase agreement, such as escrows or earnouts, or a reduction in the purchase price to offset the increased risk. If you have customer concentration above 30% to 50%, your business may be unsalable unless you’re willing to agree to a transaction structure that offers the buyer numerous protections in the event one of your customers leaves shortly after the closing. 

While the exact figure depends on the industry, customer concentration generally becomes a concern once a single customer generates more than 5% to 10% of your revenue. If the concentration level is below 5%, many buyers won’t question the relationships at all. If it’s between 5% to 10%, many buyers will begin to probe deeper and may start to consider measures designed to reduce the risk from customer concentration. If one customer generates more than 10% of your revenue, expect to agree to protective measures in the purchase agreement or be prepared to reduce the purchase price to offset this increased risk. 

Customers are a key asset of any business. Buyers consider several aspects of your customer base and metrics when evaluating your business as an acquisition opportunity.

Develop strategies for mitigating customer concentration risk before you go to market, if you can, such as asking your largest customers to sign long-term contracts in exchange for discounts. There are methods for mitigating this risk to the buyer that generally fall into one of two categories: 

  1. Actions Before the Sale: These include asking the customer to sign a long-term agreement and “institutionalizing” the client – that is, reducing the personal relationships you have with any customers. 
  2. Deal Structure Mechanisms: These include methods to assess the risk, such as customer surveys and interviews during due diligence, and mechanisms designed to reduce risk if a customer is lost, such as earnouts, holdbacks, or other contingent payments.

There are several specific methods for addressing customer concentration risk:

  • Reduce Customer Concentration: This method only works in the long term and involves diversifying your customer base so that no single customer generates more than 10% of your revenue. If you’re selling your business in the next year or two, this likely won’t be practical. For example, if one customer generates 50% of your revenue, focus on obtaining new customers by diversifying your customer base to reduce your dependency on that one customer. This obviously isn’t possible in most cases for the short term, but many businesses can diversify their customer base over time.
  • Mitigate Customer Concentration Risks: This method involves instituting measures designed to reduce the risk of customer concentration to the buyer without actually reducing customer concentration and includes the following:
    • Long-Term Contracts: Ask your key customers to sign long-term contracts. Offer incentives in exchange for signing a long-term contract, such as grandfathered pricing or other sweeteners, such as free support, discounts, or other add-ons.
    • Institutionalization: Institutionalize your relationships with your customers. In other words, reduce the level of your personal involvement with the customers. If you have a strong personal relationship with a customer, slowly transition the relationship to some of your key employees who will remain with the business after the closing. But before doing this, make sure you have also implemented a retention plan with your key employees to ensure the customer relationship transitions smoothly to a buyer. If there’s a risk that your key employees won’t stay after the closing, then such a strategy is unlikely to reduce risk for the buyer.
    • Deal Protective Measures: Deal protective measures include escrows, earnouts, holdbacks, and other forms of contingent payments. You can’t act on these items prior to a sale, but you can be mentally prepared to accept such protective measures, or you can include specific proposals in your information memorandum that are designed to reduce the buyer’s risk. By proposing specific mechanisms for reducing risk, the buyer will feel you understand the risk inherent in your business, and they’ll feel comfortable you’re prepared to ensure your business is a wise investment. In most cases, an escrow, or holdback, is more appropriate for addressing customer concentration risks than an earnout and involves a portion of the purchase price being held in escrow by a third party. The amount held in escrow would then be released over time according to a schedule, assuming the customer is retained.

Customer Contracts

Customers are a key asset to your business, and it’s wise to document these relationships. Ask your attorney to prepare an agreement between you and your customers, even if there isn’t a term to the agreement. This facilitates a smoother transition by reducing a buyer’s uncertainties regarding the value of your customer relationships. 

If you already have customer agreements in place, ask your attorney to review them to ensure they’re transferable upon a sale. In many cases, customer agreements aren’t transferable. One common solution is to structure the transaction as a stock sale, but many buyers are unwilling to do this due to the possibility of contingent or unknown liabilities. 

Unfortunately, many third-party contracts include a “change of control provision” that prevents the contract from being assigned in the event of a change in control of your business. While you could structure the transaction as a stock sale, doing so would often be characterized as a change of control as defined under such a provision and would therefore require approval by the third party. One method for skirting change of control provisions is a “reverse-triangular merger,” but this topic is beyond the scope of this chapter. If you do decide to switch your customers to contracts, be sure to include a clause addressing assignability.

The greater your customer diversity, the less risk a buyer will view in your business. 

Customer Acquisition

How healthy are your customer acquisition metrics? Can your marketing methods be automated and scaled, or has your business depended too much on your personal selling, networking, or marketing efforts? 

Start tracking your customer metrics in a dashboard and strive to create marketing methods that can be automated and scaled. Limit the amount of personal selling you do unless you’ll stay with your business after the closing. Track the metrics for each marketing strategy in your dashboard so you can establish projections based on assumptions that are backed up by your data. 

Customer Sales Pipeline

Document your sales pipeline in your CRM so the buyer can more easily project your revenue. Keep track of your pipeline, along with relevant metrics that will enable the buyer to project future sales. If your pipeline is strong before the closing, you’re in a much better position to negotiate a high purchase price than if your customer sales pipeline is weak or undocumented.

Customer Metrics

Maintain a centralized dashboard with key customer metrics and monitor your metrics on a regular basis. Watch your customer acquisition cost, customer retention, lifetime value, and other key metrics. Then develop weekly sprints with your deal team to improve these metrics over time. Track your metrics on a weekly or monthly basis in a spreadsheet so you can spot trends that can be used as the basis for the buyer’s strategy moving forward.

For example, if your customer acquisition cost lowers to $900 from $1,000, and your customer lifetime value increases to $5,500 from $4,000, you can use these improved metrics in your projections and base the value of your company on these newer metrics, as opposed to the historical metrics. 

Documenting the assumptions in your projections allows you and your investment banker to more easily defend your asking price. Your projections are built on your assumptions – so documenting and tracking your key metrics lays a solid foundation for your projections.

Close Relationships

Reduce any personal relationships you have with your customer base. Some customers may believe the only way they can do business with your company is by doing business with you. In their minds, their relationship may be with you, not your company. When you leave, their business may leave. Minimize any personal relationships you have with customers by transferring these relationships to your staff to reduce this impact during the transition. 

Action Steps

Here are tips for maximizing the value of your business when it comes to your customer base and metrics:

  • Customer Base: Build a sales infrastructure and a team that gives you the capability to acquire larger customers. Build a diverse customer base consisting of a critical mass of customers at various adoption stages of your business.
  • Customer Concentration: Minimize customer concentration. Institutionalize customers that generate a significant percentage of your overall revenue and reduce your personal involvement in these relationships.
  • Contracts: Ensure customer contracts are assignable in the event of a sale. Develop incentives to convert customers to long-term contracts, such as grandfathered pricing or free add-on modules.
  • Customer Database: Build a robust customer database that contains detailed information on your customers that allows a buyer to develop scalable, targeted campaigns.
  • Customer Acquisition: Track your customer metrics in a centralized dashboard, then track metrics for each new marketing strategy to be used as the assumptions for your projections.
  • Customer Sales Pipeline: Document your pipeline in your CRM so a buyer can easily project your revenue.
  • Customer Metrics: Build a centralized dashboard to track your key metrics. Prepare a backlog of projects designed to improve and track the improvement of your metrics over time to serve as the foundation for your financial projections.
  • Close Relationships: Reduce any close relationships you have with customers.