Revenue and value are of paramount importance to successful business owners, as well as potential acquirers of companies. However, without a strong customer base, target companies would be incapable of generating revenue or driving value as desired. Fortunately, by analyzing the target’s customer base, potential buyers can account for post-transaction risks or customer exposure in the due diligence process. This allows them to evaluate areas of concern and determine whether or not it is a deal breaker.
During customer due diligence, six areas in particular can be reviewed, analyzed and discussed with the owners and management of a target company, which are summarized below.
1. Customer Revenue/Purchasing Trends and Customer Concentrations
It is important for a buyer to understand the purchasing patterns of the target company’s customer base. To do so, consider asking the following questions about the target’s top 10 customers:
- What led to a significant increase or decrease in customer purchases year-over-year?
- Did the company experience any significant one-time purchases from a customer or multiple customers?
- What does the target company expect in terms of customer purchasing trends over the next 12 to 24 months?
- What products are being sold to the customer?
- Does the target company currently have a customer concentration, both individually and/or for the top five to ten customers?
The answers to these questions can provide meaningful insight into revenue stability, customer growth opportunities and risk of post-transaction customer attrition of the business.
Another vital piece to the customer puzzle is determining whether the target company has contracts in place with their current top customers. The following questions are frequently addressed during the course of customer due diligence:
- What customers currently have contracts in place?
- For how long are these contracts in place?
- Do the contracts have automatic renewals or automatic expirations?
- Is the target company already in negotiations with customers regarding their respective renewals?
- Do the contracts have minimum purchase commitments included?
- What is the pricing on these contracts, and is it similar to others?
- Does the pricing change based on the amount of annual purchases?
Contract-based revenue can have a significant impact on the likelihood and reliability of revenue results post-transaction, so it is important for buyers to gain an understanding of major customer contracts of the target.
Whether it is pricing, product/sales mix or other key factors, it is essential to review margins by customer to uncover variances and fluctuations in gross margin by customer each year. Once again, a review of the top customers of the target can provide insight. Consider addressing the following questions:
- Which customers result in the top gross margins and why?
- Are the revenue trends for the top gross margin customers increasing or decreasing over the periods analyzed?
- What will these margins look like in the next year?
- How can the buyer improve margins with lower margin customers and maintain or increase higher-margin customers?
- Does the company budget or target certain gross margins with customers?
- If the margin is too low, will the target company not sell products to certain customers?
The answers to these questions can inform the buyer of opportunities to pursue post-transaction, such as efforts to adjust product mix or pricing changes. Stay tuned for our next blog, which will discuss lost customers, customer acquisition and customer relationships.
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