The Customer Who Is Forty Percent of Revenue

Every banker apologizes for the same slide. Customer concentration, one bar towering over the rest, forty percent of revenue in a single name. Most buyers see the bar and start drafting the pass email before the management meeting. I have written a few of those emails myself. Some of them were mistakes.

Here is the problem with the pass reflex. The percentage is one number summarizing a relationship with a hundred moving parts. It tells you the size of the exposure and nothing about its direction.

Concentration also does something useful: it scares off the competition. The discount it creates is real and often large. If you can tell a fragile forty percent from a durable one, that discount is the closest thing to free money in the lower middle market. So the work is learning to tell them apart.

Seven Questions Before the Percentage Matters

Start with who owns the relationship. A founder's twenty year friendship with one purchasing VP is an asset that retires with the founder. Ties that run team to team, engineer to engineer, plant to plant, survive a transition. Then count the buying points. One procurement contact can end forty percent of your revenue with one decision. Twelve plants ordering independently cannot coordinate a goodbye.

Read the contracts, and read them for structure rather than comfort. A long term agreement with volume commitments and a real termination clause is one thing. A stack of purchase orders renewed out of habit is a forty percent handshake. Then price the exit: what would it cost this customer to leave? Spec ins, certifications, tooling, qualification cycles that run a year. If switching costs the customer more than your margin is worth, the concentration has a floor under it.

Check the dependence in both directions. If you are five percent of their spend but your part stops their line, they are exposed to you too, and both sides know it. Look at the customer's own trajectory. Concentration in a customer that is growing and gaining share pulls you up with it. Concentration in a declining one is a slow leak with a deadline.

Last, ask why the company won the business in the first place. Concentration built on being the cheapest bid rebids badly. Concentration built on a capability nobody else has rebids fine. The origin of the revenue predicts its future better than its tenure does.

Two companies can each have a customer at forty percent of revenue. One is a hostage. The other has a moat. The CIM prints the same bar for both.

Paul W. Swaney III

The Ladder

After enough of these, I built a four rung ladder. Every concentrated customer I look at gets placed on it, one to four, worst to best.

Rung one is the Hostage. The founder owns the relationship personally, there is one buying contact on the other side, the paper is PO by PO, and the business was won on price. The customer could resource the work in a quarter. Deal action: walk, or price the deal as if the customer is already gone and let retention be upside.

Rung two is the Vendor. The team has contact below the founder but he is still the voice of the account. There is a contract, short, without commitments that bind. Switching would annoy the customer without hurting them. Deal action: structure around the account. An earnout or seller note tied to its retention moves the risk onto the person who keeps telling you it is safe.

Rung three is the Entrenched supplier. Relationships run multi threaded, several plants or divisions buy independently, the product is spec'd in or certified, and leaving would cost the customer a year and real money. Deal action: do the deal, then spend year one deepening threads and diversifying from strength rather than fear.

Rung four is the Partner. Team to team at every level including engineering, many buying points, commitments in both directions, mutual dependence, and a growing customer whose growth pulls the company up with it. The business was won on capability nobody else has. Deal action: pursue it. This is the moat everyone else is discounting because they stopped reading at the percentage.

Testing the Rung in Diligence

The rung is a hypothesis until diligence proves it, and the tests are cheap. Ask for the contact map: every person at the company who talks to anyone at the customer. A rung four map has twenty names on it. A rung one map has two, and one of them is retiring at close.

Ask for the rebid history: when did the customer last take the business to market, and what happened. Ask the founder to sit out one customer call and listen to what the room sounds like without him. And do the reference call yourself, late in diligence, with the customer's operations people rather than procurement. Operators tell you whether the product matters. Procurement tells you what they want you to hear.

One more test costs nothing: read the receivables aging for the big customer. A customer that pays in thirty days values the relationship. One that stretches to ninety is already treating the company like a vendor it can squeeze, whatever procurement says on the reference call.

If the rung stays ambiguous after all that, let structure resolve what analysis cannot. Purchase price tied to retention converts an argument with the seller into economics. Sellers who believe their own story take that trade.

Priced by Committee, Bought by Judgment

Institutional buyers screen concentration with a rule: above some threshold, pass, or haircut the multiple to a floor. The rule exists because a committee cannot underwrite a relationship. It can only underwrite a number. The screen is rational for a fund deploying five hundred million dollars across twenty names. It is also exactly where the smaller buyer's edge begins.

My seat has no committee. As a fundless sponsor I can spend three weeks understanding one customer relationship and price the deal to the rung it actually sits on, with investors who chose that specific risk. When I get it right, I buy rung three exposure at rung one prices. That spread is invisible to buyers who stop reading at the percentage, and it is one of the few durable mispricings left in this market.

Concentration is a fact about the past. The rung is a judgment about the future. Price the rung.

Paul Swaney is the founder of Swaney Group Capital, a fundless sponsor focused in the lower middle market. LeverUp® is published weekly. More if I have something else to say.