Customer concentration risk is one of the fastest ways to misprice a deal. A business that relies on a small number of accounts can look stable on paper and still be fragile in practice. If a top customer churns after closing, your debt service won’t care that the prior three years were strong. The time to price that risk is before you sign the LOI.
This guide shows acquisition entrepreneurs and SMB buyers how to size customer concentration risk, translate it into valuation, and use structure to protect downside pre-LOI. It’s written for readability and SEO, and it uses the terms you actually search for: customer concentration, pre-LOI, SMB M&A, valuation, earnouts, and seller financing.
What Is Customer Concentration Risk?
Customer concentration risk is the exposure created when a small number of customers generate a large share of revenue or gross profit. In SMB M&A, a simple rule of thumb: any single customer above 15–20% of revenue, or the top-5 above 50%, deserves extra attention. The higher the share, the more sensitive the business is to contract loss, pricing pressure, or a key contact leaving.
Why it matters pre-LOI
- It affects valuation and multiple selection.
- It drives structure choices: earnouts, holdbacks, and seller notes.
- It shapes your post-close plan: retention strategy, coverage, and account mapping.
Step 1: Map Concentration Quickly Pre-LOI
You don’t need a data room to spot a problem. Ask for three simple exhibits during initial conversations:
- Revenue by customer for the last 24 months (monthly or quarterly).
- Gross profit by customer for the same period (if available).
- Contract terms for the top-10 customers: renewal dates, termination rights, price-increase mechanics.
With that in hand, build a one-page snapshot:
- Share of revenue for the top customer, top-3, and top-5.
- Whether the top customers are contracted or at-will.
- Any renewal cliffs inside the next 6–12 months.
- Whether the relationships are owner-led or institutionalized.
If management resists providing this basic view, that is a signal in itself.
Step 2: Size the Risk with Two Quick Checks
You don’t need an index or a fancy model. Grab last-12-months revenue by customer and do two simple passes.
A) The “two-number” check
- Largest customer % = revenue from your biggest customer ÷ total revenue.
- Top-3 % = revenue from your three biggest customers ÷ total revenue.
Use a traffic-light read:
- Green: <15% largest / <40% top-3
- Yellow: 15–30% largest / 40–60% top-3
- Red: >30% largest or >60% top-3
That’s enough to know whether you’re in normal, caution, or high-risk territory.
B) The “what-if” test
Answer three plain questions and jot the numbers:
- Renewal timing: Do any top customers renew in the next 6–12 months? If yes, circle them.
- Owner dependency: Who owns the relationship today—founder or an account team?
- Hit to EBITDA: If Customer A left tomorrow, what percent of gross profit disappears? Subtract that from EBITDA to see your downside case.
If losing the top account would cut EBITDA by ~20% or more, you’re squarely in “price and structure must change” territory.
Optional: a 60-second spreadsheet
- Column A: top-10 customers
- Column B: TTM revenue
- Column C: gross margin % (estimate is fine)
- Column D: gross profit (B × C)
Sum Column B to get total revenue; compute the largest % and top-3 %; total Column D to see how much EBITDA depends on a few names.
Step 3: Turn Concentration Into Valuation You Can Defend
Keep it simple. You have two ways to reflect concentration in price: tweak EBITDA when a near-term event is obvious, or adjust the multiple when the fragility is structural.
A) When to trim EBITDA
Use this sparingly. If a renewal cliff is weeks away or a key contact already left, take a conservative view:
- Estimate the at-risk gross profit from the specific customer.
- Reduce EBITDA by that amount (or a reasonable fraction of it) to see your downside case.
- Anchor your LOI on the validated number, not hope.
B) When to move the multiple
Most of the time, keep EBITDA intact and lower the multiple to reflect fragility. A practical range:
- Minor risk (≈15% single, sticky contract): reduce base multiple by ~0.25×.
- Moderate risk (20–30% single, mixed contracts): reduce by 0.5×–0.75×.
- High risk (>30% single or >60% top-3): reduce by ~1.0× or more.
Keep the conversation clear: “Great business, concentrated revenue. We value it, just with the right multiple.”
Step 4: Use Structure to Share the Exposure
Price is not the only tool. Deal structure lets you bridge gaps while staying aligned with the seller.
Earnout tied to customer retention
- Trigger: revenue or gross profit from named accounts.
- Window: 12–24 months.
- Payout: stepped or all-or-nothing based on retention thresholds.
- Benefit: you don’t pay for revenue that doesn’t stick.
Holdback or escrow
- Hold a portion of consideration for 12–18 months.
- Release based on renewal or gross margin from key customers.
- Works well when documentation is strong and measurement is clean.
Seller note
- Keeps the seller economically aligned during the risk window.
- Calibrate rate and amortization to cash-flow reality.
- Pair with an earnout when concentration is significant.
Transition services
- Paper a real transition: weekly hours, introductions, joint customer visits, and documentation handoff.
- If the owner “owns” the relationships, your structure should require active participation.
Step 5: Distinguish “Bad” Concentration from “Good” Concentration
Not all concentration is equal. Sort what you see into three buckets.
1) Contracted, sticky customers
Multi-year agreements, switching costs, embedded workflows. Risk is lower. Price the concentration but lean on a modest multiple reduction and a light holdback.
2) At-will or project-based customers
Short cycles, procurement shopping, discretionary budgets. Risk is higher. Use a steeper multiple reduction and an earnout keyed to gross profit.
3) Relationship-owned customers
Founder is the account manager, pricing is informal, and the handoff is uncertain. Risk is highest. Combine a lower multiple with both seller note and earnout, and insist on a tight transition plan.
What to Ask For Pre-LOI (Exact Requests)
Drop these into your early request list to keep things efficient:
- Revenue and gross profit by customer for the last 24 months.
- Contract list with start/end dates, renewal mechanics, termination rights, and price-increase clauses.
- Account ownership map: who manages each top account, frequency of contact, escalation path.
- Churn and win-back history for top-10 accounts.
- Pipeline detail for renewals and expansions tied to top customers in the next two quarters.
You can price the deal correctly with this information alone. A QoE can confirm later; the LOI should already reflect the reality.
Sample LOI Language for Customer Concentration Risk
Use plain language the other side can accept.
Valuation and structure
“Enterprise value reflects current revenue mix and customer concentration. Given that Customer A represents ~26% of TTM revenue and Customers B–C an additional ~22%, purchase price is set at [X]× Adjusted EBITDA, payable as $[cash] at close, a $[seller note] at [rate]% for [term] years, and an earnout up to $[amount] tied to retention of Customers A–C.”
Earnout metric
“Earnout to be measured as gross profit from Customers A–C over the 12 months post-close relative to a baseline of $[baseline]. Payouts at 0%, 50%, and 100% of the earnout pool at [thresholds]. Measurement to be verified from the company’s financials per GAAP, with buyer access to underlying data.”
Escrow/holdback
“$[amount] held in escrow for 15 months and released quarterly based on the same gross profit retention thresholds for Customers A–C.”
Transition support
“Seller to provide up to [N] hours per week for six months post-close to support named account handoffs, including joint customer meetings, introduction emails, and documentation of processes and contacts.”
A Simple Case Study to Illustrate Pricing
Facts
- $8.0M revenue / $1.4M EBITDA
- Customer A: 28% of revenue, annual contract with 60-day termination
- Customers B and C: 10% and 9%, both at-will
- Owner is the primary relationship lead for all three
Pre-LOI approach
Multiple. Sector base multiple ~3.5×–3.75×. Given concentration and owner dependence on top accounts, adjust to ~2.75×.
Structure. Cash at close: 70% of EV. Seller note: 15% of EV, interest-only for 12 months, then amortizing. Earnout: 15% of EV tied to gross profit from Customers A–C over the next 18 months, with clear thresholds.
Transition. Seller commits to weekly account work, scheduled QBRs, and named handoffs. Escrow holds part of the earnout pool to simplify administration.
Result
You avoid paying full value for revenue that may not transfer, and you keep the seller motivated to make the transfer stick.
Red Flags and How to Respond
- Near-term renewal on the top customer: pull back the multiple and move more value into the earnout window.
- At-will MSA with minimal switching costs: price for easy churn; insist on a holdback.
- Owner-only relationships: require a seller note and detailed transition services, or pause the process.
- Heavy discounting to keep the top account: underwrite gross margin by customer, not just revenue.
- Rapid growth from a single new customer: treat it as unseasoned revenue; use a stepped earnout.
Buyer Playbook: Pricing Customer Concentration Risk Pre-LOI
- Get the data: last 24 months revenue by customer, contract terms, and an account map.
- Quantify: compute largest % and top-3 %, then run the “what-if” test.
- Decide: adjust the multiple based on severity and transferability; trim EBITDA only for imminent events.
- Structure: combine a right-sized earnout, a seller note, and a holdback that match the real risk window.
- Paper the transfer: specific transition obligations, milestones, and measurement methods.
- Communicate clearly: show your math and keep the tone cooperative. “We like the business; this is how we make the economics safe for both sides.”
Final Word
Customer concentration is not a deal killer by default. It is a risk you can measure, price, and share. Do the quick math, show it to the seller, and propose terms that connect dollars to retention. If the risk looks high and the seller won’t share it, slow down or walk. If they will share it and help with real handoffs, you can buy a concentrated business at the right price and sleep at night after closing.
Contact us today or book a free consultation and learn how we can be a trusted partner on your next deal!
