If you’re new to the world of entrepreneurship, you may not be well-versed in the term customer concentration. But it’s important to learn it before you embark on a journey that may be not only unprofitable but costly.
Customer concentration refers to the ratio of customers to revenue share. High customer concentration means only a few customers make up the bulk of your income. As you can imagine, this is a risky situation, because if you lose one customer, it could result in devastating consequences for your business.
The goal of a business with high customer concentration is to work on landing new clients to even out the percentages and thus mitigate risk. But is it safe to acquire a business that has not yet achieved this? Is it a task you can accomplish after the fact?
Over the years we have been engaged with a healthy number of businesses vexed by customer concentration. We have seen many more we elected not to represent. Those we elected to pass on had concentration issues with little to no defensible position relating to concentration. One letter from a concentrated customer ending its relationship and the company would be toast. The final answer of whether or not to acquire a business with customer concentration should be prefaced with answers to the following questions:
1) How deep is the customer concentration? In selected industries, concentration of 10% or more might be considered high. However, generally 20% or more concentration should be cause for concern. If a customer generating revenues of 20% or more is suddenly lost, unless immediately replaced, it would have a serious to devastating impact to the bottom line. Concentration over 50% should be dismissed as an unacceptable target unless very unusual circumstances exist.
2) How easily can the customer leave? If the business servicing the customer has proprietary assets - - tangible or intangible, it can make a big difference. Simply having a “good relationship” with a customer is not enough. Differences in pricing can quickly change the mind of a customer; there is little security in a longstanding relationship where pricing is concerned.
3) What are the gross and net margins of the company? This question should be obvious. The higher the margins, the higher the degree of comfort should exist in the target company given higher levels of customer concentration. Higher margins may be indicative of proprietary products or services that allow the target company to operate very profitably. It may also indicate the targets ability to quickly replace lost clients.
4) One final question is whether the business can expand out of the concentration issue? In other words, can the business continue to grow, thus diluting the concentrated customer? Most business owners don’t want to lose their golden customer, but instead of growing the rest of their customer base (including new customers) they allow the concentrated customer to absorb more and more of their products or services.
Customer concentration can transform an otherwise profitable, successful company to an unattractive target. Buyers should be careful of courting a concentrated target company; sellers should start today on diluting in order to strengthen marketability.
--Bradley G. Marlor MBA, CBI is a Managing Partner at Utah Business Consultants and a Certified Business Intermediary with the International Business Brokers Association. Utah Business Consultants is a full-service Business Brokerage and Valuation firm.