You’ve heard that it’s risky to “put all of your eggs in one basket,” but did you know that the risk of having too few customers can actually translate into decreased business value
How does Customer Concentration impact value?
First, as a reminder, business valuation is based on both qualitative and quantitative factors that impact
- 1) Future cash flows; and the
- 2) Discount rate (or rate of return) to discount those cash flows back to current value
One of the key qualitative factors that could impact future cash flows and discount rate is called Customer Concentration, or how revenue is spread across the customer base. We’ll share some numbers to help you determine if a specific business has customer concentration issues, but in short, if too much revenue is concentrated with just a few customers (i.e. all your eggs are in one basket) it increases the risk that losing one key customer means losing a significant percentage of revenue. With increased business risk we increase the discount rate, and that reduces present day value of those future cash flows.
There are many factors that impact a business’s future cash flows and discount rate as we look at the specific qualitative and quantitative factors, but as mentioned, Customer Concentration is one of the qualitative factors. The good news is that with time and attention there are actions that can improve the situation beyond just finding more customers.
Is there a problem with Customer Concentration?
These two questions will help determine if the business has risk associated with customer concentration issues:
- 1) Does any single customer represent 10%+ of total annual revenue?
- 2) Do the top 5 customers, based on combined revenue, represent more than 30% of total annual revenue?
How can business owners reduce Customer Concentration risk?
One obvious solution is to get more customers, right? But we care about the quality of customer relationships, not just quantity. The wrong customers can lead to other issues. So while looking for more “right fit” customers is a goal to help diversify customer mix, here are four additional considerations that impact how we calculate the significance of the customer concentration as part of our business valuation analysis:
- 1) What is the tenure of the relationship? Has the relationship been successful for 5+ years or is it a new relationship? Typically if a relationship has been in place and has been working well for a long time it usually takes longer to end it. Longer-term relationships lead to reduced risk that the relationship will end suddenly, and therefore a lesser increase to the discount rate, resulting in a favorable impact on business value.
- 2) Does a contract exist? Is there a contract in place that includes terms that require notice before the customer can stop orders/doing business? Even if the required notice is short, a contract is a commitment between two parties to work together. The longer the contract terms state, the lower the risk of sudden loss of revenue, and therefore less impact to the discount rate. Reducing the level of the discount rate has a favorable impact on value.
- There are additional factors to consider with contracts based on what potential buyers would look for, such as whether the contract is assignable should there be a change in ownership or surcharge language that allows for price increases to be passed along to the customer, to name a few examples. As a result, these types of contract stipulations/terms can also impact business value.
- 3) Are there multiple relationships within a customer’s business? How many people in the customer’s business does the company get orders from or have a relationship with? If a business has numerous relationships within different areas of a customer’s company that is better than one person in one department. Having a sole relationship in a company means higher risk if that person decides to leave or retire. If there are multiple relationships across multiple departments it reduces the risk and decreases the discount rate, having a favorable impact on value.
- 4) How deep are the relationships? Is customer care a focus for the company? For example, does the company have a dedicated salesperson or employees who are embedded in the customer’s business and possibly even go to work there every day? Or, are there regular face-to-face touch points throughout the year, even if virtual? Does the company invite the customer to special events to say “thank you” in other ways?
- Having a consistent relationship of any level is far stickier than “I’ll send you a PO” or a fully automated transaction every time. Not to say automation is bad, in fact, smooth operational systems can have a positive impact on business value. The idea here is that when it comes time to reassess vendors, we look to see if the business is likely to be considered a valued partner to the customer, not just a vendor that is easily compared on price.
These four considerations can be thought of as levers that can impact the degree to which Customer Concentration is considered a risk factor when it comes to how a buyer would evaluate a business investment, as well as part of a formal business valuation analysis. It is not atypical for privately owned businesses to have key customers. Whether a business finds itself with customer concentration issues, or not, these four considerations can help strengthen its position by further reducing risk.
As you’ve heard us say in past articles, whether a business owner plans to sell in the near future or not, continuing to evaluate the business as a buyer would evaluate it helps the owner manage their business as an investment -- working ON the business not just IN the business.
If you would like to discuss a specific business situation please reach out to us through the Contact page or call us at 608-257-2757 and we’ll connect you to a business valuation expert on the Capital Valuation Group team.