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Enhancing Value: Managing Customer Concentration

Posted by David Humphrey on 24 April 2014 | Comments

As your doctor will tell you, everything in moderation is OK.  However, when there is too much of one thing, even the things that are good for you, problems can occur.  Too much revenue from  one or a small handful of customers can be too much of a good thing.

We love customers and want as much work as we can get from each one, as all profit start with revenues.  Buyers worry about the risk they are taking on when they buy a business.  One of the things they worry about deeply is an “oops” with a client, especially early on after the purchase but before they have yet developed a strong relationship and trust factor with the client.  They worry that the client will leave or significantly reduce the volume of work.  They also know that customers leave in the regular course of business for all sorts of reasons outside of their control – customer’s product mix changed, they were bought by another entity who buys product from someone else, the purchasing manager changed and now wants to give the business to his cousin, and so many more reasons.

If it is a small client that barely registers on the income statement, the business needs to learn from the mistake, work to find a new customer to replace them and move on.  However, if the “oops” or change occurred on a significant customer account, moving on can be difficult and the change is sometimes fatal.

Many buyers have strong opinions about the amount of business provided by one customer that crosses the risk threshold them.  For some buyers the threshold is 10%, for others it is 20%, some look at the number of customers that make-up half the business’ revenues.  Almost all buyers agree that more than 30% of revenues from one customer raise a red flag.

The effect of a customer concentration on a business value ranges from buyers walking away, to reducing the value in their offer to account for increased risk, to the seller being required to accept an earn out based on client retention.  None of these are ideal situations.  In the years leading up to sale, owners can consider options to mitigate this buyer concern, including:

  • Add new clients, to make each current client less important
  • Show that the “large customers” are really made up of several small customers each with autonomous purchase decision making, or
  • Consider buying a competitor to reduce the overall impact as a percent of sales your significant customer represents. 

Planning note:  Buying a competitor is a very significant step but can also be a very lucrative one.  Consider this:  Frank has a business which would normally be worth $1,000,000, however he is only getting offers in the $800,000 due to one customer accounting for 30% of revenues.  His competitor, who is of similar size and profitability, is in the same boat also having a significant customer.  Frank buys the competitor for $800,000.   A year later, Frank goes to sell his company with revenues twice as high.  His largest customer is only 15% of revenues, not 30%.  The competitor’s largest customer, now part of Frank’s business, is only 15% too.  Thus, even before economies of scale by combining the two businesses are considered, Frank has increased the value of his business by $200,000 and the competitor’s business by $200,000 by reducing the customer concentration risk.  The $800,000 purchase of the competitor increased Frank’s net worth by $400,000 with the acquisition.