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What Is Retention Marketing? Retention marketing is basically all the channels that we use to keep...
So why does due diligence matter? Why conduct any due diligence around revenues before you sign that purchase agreement?
Ultimately, conducting due diligence protects your investment and it looks to limit the risk associated with the particular investment.
When it comes to small business acquisitions which are unaudited, there is an inherent risk that goes behind the investment.
The same applies to buying a small business.
The challenge is it's significantly riskier.
When you're buying a small business, which is unaudited, it largely has never been verified from a financial health perspective.
The company will show revenues, they'll show costs, and they'll show profitability.
All of those things are just numbers that need to be verified as truth.
In small business deal making, there is no verification that the revenues, expenses, and net incomes of the company actually exist.
So conducting due diligence at the core of it is verifying the financials of the company.
If the company says it produces a million dollars in net income, going into the accounting records and verifying that it is something which is the first part of this financial due diligence equation.
Customer Relationship Analysis
When we think about the customer relationship analysis, it's really broken into four pieces.
It's what is the sales stability of the customer base.
You do this by examining the consistency of customer purchasing patterns over time.
Is the company getting more customers each month?
Is the company losing customers each month?
Understanding if the company has seasonality.
Does the company have concentration?
Is there an over reliance around the company's customer base?
What is the relationship strength of the customers?
Have the same few customers been around for the company's entire existence?
Is it relatively new?
What are some trends?
Understanding the diversity and the mix of the customers.
Tracking whether the customer base is becoming more diverse or more concentrated over time is also really important.
These are just a few things to set the stage for the customer analysis and why it matters.
Customer Concentration
When we think about the customer concentration analysis, it's really to understand revenue distribution across the customer base and to identify if there is a risk for high customer concentration because that can leave the company vulnerable and impact valuation.
When it comes to revenue concentration, I like to plot out a top five or a top 10 customers.
Typically customers with revenues greater than 15 or 20% of total revenue pose a risk to the business.
In aggregate, it might not be as material, but thinking about the percentages is a good way to set the stage when you're doing this preliminary analysis.
When you do receive the financial data, what I'll do is I will put together a customer list.
That'll show what is the company revenues look like and then where is the company getting those revenues.
One example of a top customer list shows that the top 10 customers roughly comprise 26% of total revenues.
In my opinion, that's a very healthy customer mix.
Customer one and customer two are really the only ones with significant revenues, like 5% of total.
In large part, especially for small businesses, this is actually a very healthy customer mix.
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Customer Retention: MRR, ARR, and Churn
When we think about customer retention, this is how long is a customer being retained by the company.
This speaks to if you're looking at a business that has monthly revenues or recurring revenues.
There are two key phrases.
MRR is monthly recurring revenue and ARR is annual recurring revenue.
If your business has project-based and doesn't have a monthly fee, this is largely not applicable.
But understanding the lifetime value of the customers regardless of a subscription or not subscription type business is very important when you're doing this preliminary analysis.
You want to see customer retention high.
You want to see instances of expansion revenue which shows that the company is actively trying to do add-on services and increase revenue over the lifetime value.
And then you want to see what is the actual margin and what is the profitability of these customers.
Margin Analysis and Profitability by Customer
Assess the margin quality by customer.
The profitability analysis is what I call the customer by margin analysis.
It looks to show what are my revenues by customer but more importantly how much money am I actually making from a profit standpoint for the customer base?
Because if you have a customer which you actually may be losing money on or it's a break even endeavor and with labor you're losing money, you need to be made aware of those things.
Those types of customers might not make sense for you as a new buyer.
For example, high margin accounts.
The top three customers in this instance were generating 45% of gross margin through premium pricing and efficient service model deliveries.
The question is, is the rest of the customer mix not taking you know is the company not able to sell those premium high ticket items to the rest of the customer pool?
Because if they're not, those customers could be actually outside of the normal type of customer.
If you lose those high ticket premium pricing the company's financial performance could significantly decline.
These are what I call margin pressure points.
You have a customer pool with potentially on paper the company has high margins but it's derived from two or three of the top customers.
The risks of buying a business like this is you need to assess is it reasonable to assume these high ticket customers will stick around post-close and what does life look like when I transition as the new business owner.
Cohort Retention Analysis
When we think about customer retention analysis, one thing I like to do regardless is set up what is known as a cohort analysis.
This cohort analysis looks to do a few different things.
It looks to show what is the customer count look like on a month-to-month basis.
It looks to show what is the lifetime value of the customers over their typical life cycle.
A cohort is a group of customers who all sign up in the same month.
Customer retention by cohort looks to see what is the churn and the customer life cycle of some of these customers as they come in.
In January, February, March, and April, about 74% of the customers were retained.
By month 11 only 26% of those original customers were still around.
On the flip side, in June by month three or four the company had 95% retention for the customers.
So even so if we compare it from January to June the company did something differently to retain these customers and prevent churn.
The question is what did they do?
This is an analysis that I will conduct early on in financial diligence and I would ask them the question what changed in June?
Did you run a promotion in June where you had something like one month free or a 15% discount if you locked in for 3 months?
Maybe they brought in a few more customer service representatives to better communicate with the customer mix and there was an overall higher sentiment with the product being delivered month over month.
This analysis and any revenue analysis you conduct is to be leveraged for conversations with the company.
If you're a prospective business buyer looking to purchase a small business, any analysis you're doing is to be leveraged as a talking point with the sellers as you learn more information about the company.
In this instance, the company ran a marketing advertising promotions for discounts of effectively if you lock in for 3 months, you were able to receive 15% off.
In addition they hired a few more customer service representatives which overall led to less churn in those months.
Net Revenue Retention
A lot of questions I get is what is the net margin by customer or how is the company performing month-to-month year-over-year compared to 2024 compared to 2025.
There is an analysis called the net dollar or net revenue retention which effectively looks at the revenues by month and compares those to the revenues earned month-to-month.
For percentages above 100% that is what is known as expansion revenue.
This is very favorable for companies and analysis regardless of the type of business you're buying.
This is an indicator that there is an incremental increase in customer revenues of the existing base.
Think add-ons, different initiatives to boost customer revenue month-to-month.
On the flip side, if you see items that are under 100% is due to a factor of churn, some customers electing to reduce monthly revenues, etc.
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Lifetime Revenue and LTV Analysis
The cumulative lifetime revenue is an interesting analysis because it looks at what is the expected lifetime revenue of a particular cohort or customer over the original offering compared to 11 months into it.
The January cohort spent about 1,750 in total revenues.
By month 11, that revenue has increased to 14,200.
It does show the revenue growth of these customers from a $50 subscription.
The most important piece of understanding the lifetime revenue is double clicking and understanding the customer lifetime revenue on an individual customer.
This shows one customer how much revenue it will give you over a 12-month time frame.
Why is this metric important?
This metric is important because if we are running ads and trying to understand what is our customer acquisition costs, hypothetically let's say our customer acquisition costs were $115.
By month three we have broken even and are starting to become profitable with this customer and the rest of it is pure profit.
When you're looking at customer lifetime revenues, month-to-month changes, breaking it down into the life cycle of the customer and the profitability is very important.
You want to see customer retention high.
You want to see instances of expansion revenue.
And then you want to see what is the actual margin and what is the profitability of these customers.
CAC vs LTV
This example assumes the company is producing 65% gross margins.
For every $50 monthly fee, the company is profiting $33.
Over a 12-month period, each customer will bring in a profit of $264.
This is why customer lifetime revenues, month-to-month changes, the life cycle of the customer and the profitability are very important.
Where Customer Analysis Fits in Financial Due Diligence
When you kick off financial diligence you want to assess these in the analytical procedures.
You would be analyzing historical financial performance, analyzing trends and revenues and customers.
This also goes hand-in-hand with the income statement review.
It'll assess the per product per customer profitability.
There are several layers of this analysis when it comes to financial diligence.
Understanding the revenue quality is critical.
What Data You Can Request Before LOI
You can ask for things like customer data without the names of the customers or customer counts.
Or you can ask for any revenue if they're willing to share.
Unfortunately, until you are under LOI, a lot of the company secrets likely won't be shared with you because rightfully so, the sellers will be cautious to provide that information.
But I would focus on things like revenues, trending revenues month-to-month, especially year-over-year.
If revenues are declining or month-to-month revenues are not performing well, any sort of detailed revenue analysis likely will say a similar story.
That's typically how I think about the pre-LOI diligence.
Once you are under LOI, I would request customer reports, sales reports, invoice detail, etc. to do some of these analysis.
Year-to-Date Performance Analysis
Putting together something that looks like what is the year-to-date performance analysis.
This is a typical trend chart.
It plots out the total revenues in line with the current client base that are active over the last trailing 12 months for closed fiscal year.
In this instance, revenues are remaining relatively stable month-to-month.
Certainly, there's some fluctuations, increases and decreases, but overall the active clients are actually increasing.
This is very favorable for some companies, especially those focused on monthly recurring revenues.
Doing a customer count analysis can be important.
If you plot out customers who are added, so new ones, and then losses, this can show you again what the customer mix looks like month-to-month.
These are tools to use for talking points when you speak to management and the rest of the company when you're doing this analysis.
Red Flags: Anomalies, Margin Drops, Revenue Spikes
The red flags and key insights report is really like a four-step process.
The first is you want to be able to analyze and detect the fluctuations and anomalies within the financial data.
Then ask yourself, what are the root causes of the analysis I'm looking at?
Is revenues performing well month-to-month?
Are they beginning to decrease?
What does that actually look like?
You want to recommend and think about what are some of the strategies and analysis I'd like to conduct after dissecting what does the financial data look like.
Then from there after you've detected and analyzed you can request some of these data documents to conduct the net revenue retention analysis, conduct a customer analysis, etc.
Until you go through this process of analyzing the data and then moving thoughtfully throughout your due diligence, you probably won't get to some of the answers you need.
Some of the red flags to watch out for are unexplained revenue spikes or decreases.
Declining margins is another big one.
Many people can follow the revenues and those changes month-to-month, but they aren't focusing on the margins of the business.
In my opinion, the margins actually tell a better story of how the company is performing.
Why Margins Tell a Better Story Than Revenue
The margins of a company will show you how is the business performing month-to-month from a profitability standpoint.
When I look at a company's P&L, I like to immediately go to the margins of the company.
Over a four-year period roughly the company was producing 25% net margin in 21, 9% in 22, 12 and then a 29% in 2024.
What changed with the business?
All of a sudden this business which has roughly the same incomes at least in 23 and 24 is significantly more profitable.
By starting at the margin analysis and looking at the net margins month-to-month or on an annual basis, you can start to develop a plan and a question list of what do I want to ask the company about?
The first question for this deal was why did the company produce similar revenues year-over-year but is significantly more profitable?
The cost of goods sold declines slightly about 70,000.
More importantly, the company is using less operating expenses.
Something in their cost pool changed favorably in that they were able to produce similar revenues with less costs.
When you're looking at a company and you see the net incomes or the profitabilities, the first reaction is to think, the company must be performing well.
People associate performance with topline revenue, but that's not always the case.
It could be they cut costs and are therefore profitable.
They could have expanded revenues like the expansion of revenues in customer base.
Or there may be an accounting issue with how these costs were recorded.
There could be scenarios where the company changed accounting methods or are changing how they record costs month-to-month.
Working with a CPA or a due diligence team, their first initiative would be to make sure that they're properly recording these costs in line with how they did in prior periods.
Closing Thoughts
Conducting a proper cohort analysis can be quite time-consuming.
It does show you the health of the business.
It shows you what does the customer retention look like.
It'll begin to give you the knowledge about the company.
Is this the type of business I want to own where the company has significant churn?
If you think about onboarding and offboarding clients, it can be quite time-consuming.
On the flip side, does the company have churn?
These are really just to arm you with the facts around these types of acquisitions.
When I think about my business and investments, I focus a lot of my efforts in the lifetime value of the customer when it comes to pricing.
Regardless of the industry you're in, you can see and you should conduct an analysis that shows what is the first ticket fee I'm collecting from customer A?
And then how much is customer A paying me over a three-month life cycle, a three-year life cycle?
Because that'll show you is the company pricing correctly?
Could there be opportunities to price it differently?
Understanding the revenue quality is critical.
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