Dealing with Customer Concentration Issues

Business brokers and advisors know that an expansive, diverse customer base is a great selling point for any company. Buyers consider customer concentration significant risks and are vigilant in measuring this risk. The presence or absence of customer concentration is one of the first questions to which buyers want answers.

Customer concentration reveals the distribution of your total revenue among your customer base. So, if your company has a large number of small customers, it has a lower customer concentration. On the contrary, if a small number of customers accounts for the entire business, customer concentration is high.

Industry type may also determine low or high customer concentration. For instance, a retail store generally has low customer concentration, whereas a construction company may have only a few big clients, leading to a high customer concentration. Both low and high customer concentrations have their share of benefits and risks. But in the long run, the risks of high customer concentration far outweigh the benefits.

Buyers negatively view high customer concentration at the time of due diligence, which may lower the company’s valuation.

High Customer Concentration Factors

As a rule of thumb, the company faces a high customer concentration issue if:

  • A large percentage of business is with one customer.
  • The top five or ten client accounts bring maximum revenue for the business.
  • The top five customers provide 25 percent or more of the total revenue.
  • The maximum of high margin work is with one client or group of clients.
  • You provide customized work to the most significant customer, and it does not flow through regular channels.
  • The largest-volume customers provide the lowest margin.

Before taking your company to market, understand customer concentration risk from the buyer’s perspective. After acquiring the company, buyers stand the risk of losing those high-priority customers who bring maximum revenue. Those customers may stay with the new company or seek alternatives when management changes, drastically lowering revenue.

When buyers see customer concentration risk, they must adjust their plans and alter the purchase offer to compensate for the assumed risk. They can do that by moving funds from “guaranteed” to “contingent” or by reducing the price they are willing to pay or both.

Business owners usually understand that a single account dominating revenue is a problem that needs to be resolved; however, they fail to understand:

  • Where their best margins come from and why,
  • The top 25, 30, or 50 percent of revenue comes from a small group of clients,
  • That if customization is not scalable, it is a form of concentration.

Business owners also need to understand that high customer concentration creates trouble for prospective buyers planning to take loans to complete the M&A transaction because even lenders and lenders view high customer concentration as a problem. To service debt, bankers and lenders look at the buyer’s ability to continue earning the same level of revenue and profit. High customer concentration poses too significant a risk unless the buyer can justify the risk, diversify away from the risk, add new customers, add resources, etc.

Related: Rush to Market. 

Dealing with Customer Concentration Issues

Delay the Sales Process

Business owners need time to resolve customer concentration issues before taking their company to the market. Buyers want security and confidence in their purchases. When business owners eliminate the risk by employing sufficient resources and time, buyers reward them handsomely with higher purchase offers.

To acquire new customers and break the concentration, business owners need to apply diversification strategies and ensure that majority of their revenue does not depend on customers from a single industry or demographic segment. Such efforts will increase the reliability of the company’s future revenue stream and enhance its business value.

Show the Benefits of High Customer Concentration

A good advisor can flip a negative to a positive by showing how the wisdom and benefit of the company concentrating on a high-margin client, and stopping work with low-margin clients. The advisor can also point out how large customers have a vested interest in the company’s success and provide valuable input to improve the company’s products or services. The advisor may also highlight the strong relationship, as the company serves its customers more as a partner than a supplier.

Enter into a Contractual Agreement with Customers

The business owner can also demonstrate that high concentration poses little or no risk by getting customers to enter into contractual agreements for continued services, prices, or products and ensuring that those agreements are transferable.

How to Sell a Business with a Customer Concentration Problem

Business owners should seek out buyers who have a strategic reason to feel comfortable with customer concentration. Such buyers:

  • Have a desire to enter your geographic area.
  • Have more capacity and resources to add new clients and reduce concentration risk.
  • Have complementary products or services that they can offer to their customers and break concentration.
  • Do not work with the company’s group of customers.

Buyers can deal with the high customer concentration issue by:

  • Keeping the seller involved so that they achieve a smooth customer transition after the deal.
  • Motivating and rewarding employees for introducing new clients and reducing customer concentration.
  • Merging the high-risk acquisition with a low-risk business unit.
  • Renegotiating terms, volumes, and prices with existing customers to better align with their risk tolerance.
  • Creating a contingency fund for customer retention.

Summing Up

Business owners must look at their company from the perspective of potential buyers and lenders before they plan a transition. They should know what makes their company an appealing M&A target. Diversifying their customer base may earn a premium at the time of exit.

Even if the company faces high customer concentration issues, an expert advisor can help a business owner turn a negative into a positive by eliminating the risk or even selling the company to buyers who are unaffected by the problem.

New call-to-action

Author Summary:
Dan Doran

Dan Doran

Is the Founder of Value Scout, Quantive and the 2019 Exit Planner of the Year. He is a recognized expert and speaks frequently about M&A, valuations, and developing more deliberate value creation strategies.

Explore By Topic:

Categories:

Subscribe

Stay up to date with monthly blog highlights.

Hidden
Form Fill Label
This field is for validation purposes and should be left unchanged.

Follow us on Social Media

Recent Posts: