Customer Concentration Risk

The level of customer concentration for a business refers to how its overall revenue is spread out among its various customers. A business is deemed to have high customer concentration risk when its top customer constitutes at least 10% of its overall annual revenue or when its top five customers constitute at least 25% of its overall annual revenue. When it comes time to sell, many buyers (and banks when appraising businesses for lending purposes) scrutinize the customer concentration of the business carefully during the due diligence process. The concern about a business with high customer concentration risk is that if one or more of its top customers are no longer customers after the sale (for whatever reason), then the value of the business will be seriously impaired due to the inordinate amount of lost revenue and profits.

Prepare Business to Sell by Lowering Customer Concentration Risk

Most businesses – particularly in the retail industry – have little or no customer concentration risk because their overall revenue is diffused over a great many individual customers. Other service-oriented businesses such as construction-related companies servicing large projects or staffing agencies servicing a few select large corporate customers may face high customer concentration risk and should take proactive measures to reduce this risk prior to selling. Broadening a company’s client base by is no easy task and may take a long period of time, but business owners who do so will receive a higher valuation for their business from the reduced customer concentration. A business with a diverse and broad array of customers makes its future level of cash flow more certain and thus elevates its valuation.

Example of Business Sale with High Customer Concentration

Stan is thinking of selling his local staffing agency.
The staffing agency provides local and regional businesses with temporary office and clerical employees.
Stan consults with a business broker, who notices that about 30% of Stan’s overall revenues is from staffing office and administrative positions in a large attorney group with multiple locations throughout Southeast Florida.
Stan is proud of the fact that he has such a large customer as it took him years to solidify this relationship.
Stan does not realize, however, that his company has a very high risk of customer concentration.
This will pose a serious problem for many buyers in two important ways.
First, buyers will fear that the large customer may at some point in the future find a cheaper and more efficient source of labor or otherwise discontinue its relationship with the staffing agency for some unknown reason.
The risk of this happening may be fairly small, but the impact on the staffing agency after the sale would be catastrophic.
Second, buyers will fear that without Stan and the personal relationship he maintains with the large customer, the large customer may defect after the closing.
The broker discusses this with Stan, who decided to wait a year or so before selling.
During this time, he will diversify his revenue stream by focusing his resources and pricing power on generating new business while stepping back from an active relationship with the large customer.
After bringing down his customer concentration risk to an acceptable level, Stan will receive a significantly higher valuation for his business.
Lastly, Stan will develop a smooth transition plan where he will agree to stay for a time after the closing in order to assist the buyer with maintaining the customer relationships.

Third Party Referral Sources

Sometimes a significant part of a company’s customer base is referred to a business by a third party referral source. Here, it is the referral sources rather than the end-customers that affect whether the customer base will be retained by the buyer after the sale. A business may have low customer concentration in the sense that its revenue is dispersed among many different customers, but its key third party referral sources may still pose a significant customer concentration risk for the buyer. For example, a home healthcare business may receive the majority of its patient referrals from just one or two physician groups. Business owners that derive a large percentage of their revenue from such a small amount of referral sources should diversify their referral sources and ensure that the referral sources are not dependent on the presence of the owner.

Confidential Sale

A business with a high risk of customer concentration underscores the need for a confidential sale when it comes time to sell the business. When a business has one or more key customers or referral sources, it is absolutely critical that they not find out that the business is for sale. If this happens, then the large customers or referral sources are more likely to cancel or reduce its relationship with the business due to fear and anxiety. A confidential sale prevents the true identity of the business from being disclosed without a properly qualification process which includes signing a Non-Disclosure Agreement (NDA). The NDA prohibits the prospective buyer from alerting any customers or referral sources about a pending sale or otherwise contacting them in reference to the business being sold.

Customer concentration risk is a key metric used by buyers and lenders when evaluating companies for sale. An elevated risk of customer concentration jeopardizes the future level of cash flow expected from the business and thus its valuation. It is always best for the business owner to first reduce the level of customer concentration prior to selling. If not, then the business owner may emphasize to buyers how and why the key customer relationships will be maintained after the sale. If the customer relationships are longstanding and recurring in nature, then the risk of customer concentration will also be reduced.

Give Martin at Five Star Business Brokers of Palm Beach County a call today at 561-827-1181 for a FREE evaluation of your business.