What is Customer Concentration Risk?
Customer concentration risk is when a large amount of a company’s sales are derived from a disproportionately small pool of customers. The bigger the client relative to total revenue, the greater the risk the revenue holds.
As an example, let’s imagine a swimming pool servicing company performs cleaning and maintenance for pools within a local area. The company’s largest customer, a community recreational facility, makes up 25% of its revenues. What happens if this customer experiences difficulties and suddenly closes the facility? Or for whatever reason, decides to go with another provider? The swimming pool servicing company will receive a tremendous revenue hit overnight, and the lost revenues could be completely out of its control.
As the old saying goes: “don’t put all your eggs in one basket”. The last thing you want is an email that comes in late Friday afternoon from your largest customer informing you that they will need to part ways with you.
How Does This Affect Company Value?
As you can see, a concentrated customer base increases the risk to business owners- both present and future. As a result, when assessing the value of a business, potential purchasers seek to shield themselves from future risk by carefully observing the customer base and the durability of future cash flow.
When analyzing a company to purchase, prospective buyers will look far beyond a company’s high-level financial numbers; and in fact, will look at how those values came to be. A company can have wonderful sales and profitability but have 80% of their income come from three customers. The buyer’s assessment will ultimately be reflected in the price they are willing to offer.
Some of the common buyer questions, as it relates to high customer concentration, will be:
- What would be the impact should the company lose a major customer?
- Are there contracts in place with larger customers? If so, can they be transferred to a new owner?
- Are the relationships with such larger customers exclusive?
- Does a loyal relationship exist between the customer and the seller and could the account be in jeopardy should there be a change in ownership?
- Does the customer enjoy a preferential treatment that would be hard to find elsewhere (ex: pricing, unique product, etc.)?
- How much friction is involved for the customer to switch to a competitor? And, what could potentially cause that to happen?
Strong perceived risk from the buyer in this area will likely result in a lower offer or alternative deal structure to bridge the risk gap. For example, a portion of the total purchase price may be held back for a period of time should a major customer elect to leave shortly after closing.
Another example could be an earn-out. This is where the seller receives part of the total consideration into the future based on the company’s performance post-close. Naturally, these types of structures place some of the liability back on the seller and are put into place to offset the amount of risk to be assumed by the buyer.
How Much Is Too Much?
The smaller the concentration, the better as it insulates a business’ financial performance from the potential loss of a customer. Generally speaking, buyers typically look for a customer base in which no single client accounts for more than 8-10% of total sales. Of course, this expectation varies case by case depending on the nature of the business,
It is important to note that having high customer concentration doesn’t mean a business won’t sell. Rather, it means that a buyer is less likely to pay a premium for it and will be more likely to invoke one or more of the above-mentioned tactics to reduce their risk. In the section below, we will discuss some strategies on how you can work to reduce customer concentration risk.
Strategies On How To Shrink Customer Concentration
Taking a step back to look at your business from a buyer’s perspective will allow you to see potential changes you can enact today to make it more appealing (and more valuable) as an acquisition target.
Understanding your current vulnerabilities will help you plan, manage, and mitigate the revenue risks you could face down the road. Further, knowing some strategies on how to diversify your customer base will, in turn, alleviate those risks.
- Introduce new, complementary products/services. Having your customers buy several of your offerings signifies a co-dependency and solid relationship with the customer.
- Sign long-term contracts. Although this strategy doesn’t minimize your top customer’s impact on your revenue, contractual income can significantly soothe a buyer’s fear of losing those customers when the business transfers hands.
- Upsell smaller accounts. Making your smaller customers account for more of your total sales will make you less dependent on larger customers.
- Expand geographic locations served. Reaching a new region can open the door to a fresh set of potential customers.
- Partnerships/joint ventures. Working with synergistic companies on projects can increase your collective value proposition and unlock new opportunities to gain new business and spread out reliance on existing large accounts.
All told, customer concentration is a serious issue for any buyer and the retention of major customers through a change of ownership will be a predominant concern. Proper preparation and reasonable expectations around deal terms will increase the probability of successful sale and a fair purchase price for all parties.