Customer Concentration

Although this year has been the exception, buyer activity typically slows down during the summer, and picks up with intensity after Labor Day, as the vacation season ends and buyers realize that there is still time to complete a transaction before the end of the year. In anticipation of this increased buyer activity, our firm is actively engaged in bringing additional businesses to market. During this process, we find out the good, the bad, and sometimes the ugly about some clients and potential clients. The issue of customer concentration falls within this rating system and is the topic of this month's article.

The Good: A large, highly diversified customer base(both geographically and industry types), with many small customers and no customer accounting for more than a few percentage points of total sales or profitability. This can add value to a business. It not only reduces the risk to a buyer and lender in the event after customers no longer elects to do business with the buyer, but it can be very attractive and worth more to a buyer that can sell additional products to that existing customer base. An e-commerce business might be an example of this type of customer profile.

The Bad: Customer concentration usually does not become an issue as long as no one customer accounts for more than 10% of revenue or profit. It may also not become a problem within the 10% to 20% range, depending on trends, relationships, contracts, etc. When the customer concentration gets above 20%, it usually generates a conversation from the buyer, the buyer's advisors, or the lender relating to the management of the risk to the buyer. A manufacturer of automotive parts might fall within this category ,as there may only be a limited number of potential customers.

The Ugly: When there is a customer that accounts for 50% or more of the business' sales or profits, the perceived risk to the buyer or lender increases to a point that the customer concentration becomes a significant part of the negotiations. Most business owners are aware that customer concentration is not ideal, but economic circumstances may come into play, such as when a good customer is growing and continues to absorb the production output of the business. Dealing with a good customer that pays on time and is easy do deal with can become a path of least resistance and a trap for the unwary. We often times will see this when the owner has done well and does not have the energy or motivation to diversify the customer base. A subcontractor for a large home builder might fit this description.

The problem of customer concentration can be mitigated if it is addressed in advance and through a variety of risk sharing structures.

(originally published in September 2015 eNewsletter)