Customer Concentration and Its Effect on Business Value

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It’s common for businesses to partner for years, or even decades, with a handful of very large customers. But this can make them too dependent on too few sources of income. Any move made by the customers would cause an equal or greater reaction in your business. If you’re planning a sale, the time has come to assess customer concentration and weigh how it might affect value.

Initial Disclosures

Initial disclosures in your informational memorandum (or deal book) should include a section dedicated to customer concentration. This is a very revealing section because every acquirer wants to know what will happen if you lose one or two of your biggest customers.

So is heavy concentration at the top of your customer list inevitably terrible? Not necessarily. If those top performers pay on time and are predictable, that can counterbalance some risk. In fact, it’s common for businesses to get 40% or more of their business from 10-12 customers. Moreover, many large customers take less time to serve, offer helpful technology, and function like well-run machines. Invoicing may be simplified, and payments are more likely to timely arrive.

In this regard, high-quality receivables from large buyers may be a liability. That is until there’s too much concentration in a single account or two. A good rule of thumb is that no single customer should generate more than 10% of revenues. Anything more than that is a red flag that points to the potential for disruption.

What About Gross Profit Margins?

When assessing customer concentration, a potential acquirer will also want to look at gross profit margins (GPM) for each customer on the list. Their interest is about more than just curiosity. It’s because if you’re heavily discounting your highest volume buyers, expecting to make it up on volume, this puts you in a vulnerable position. It suggests you are selling large volumes at low margins, which can erode overall value. GP discipline, even among long-term large-volume customers, is a clear indicator of a well-run business.

However, if your GPMs are similar to the GPMs you maintain for other down-list customers, you are likely running a disciplined operation, and have stuck to your guns regarding pricing, even with high-volume accounts. Discipline is a hallmark of a well-run business.

The One Calculation You Must Do Now

Before you put your business on the market, calculate customer concentration. This instructive exercise reveals much about your vulnerabilities— perhaps even if you don’t intend to sell. Create a spreadsheet of your GPMs as you do so, then compare those to the GPMs of the smallest customers on your spread. How do they compare?

If you intend to seek an acquirer, the time to make adjustments is now. When you’re finally ready to unveil your financials to potential acquirers, you’ll be able to do so in a way that reassures them that you’ve been disciplined and remained within accepted GPM norms for all customers, not just those who form the bottom portion of your customer list.