Oct 19, 2022
Customer Concentration in Small Business Sales
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When small business entrepreneurs consider buying a small business, among the first questions they’ll ask is about customer concentration.
Customer concentration occurs when a business is overly reliant on a small group of customers or clients. There are various ways the question is framed: How much of a business’s revenue is from its top customer? How much revenue is from the top 5 customers?
In this post, we’ll dig into why customer concentration matters, how to calculate it, and what to do about it.
Why does customer concentration matter?
Customer concentration measures how reliant a business is on a few customers. From the perspective of a small business owner, high degrees of customer concentration represent risk.
For example, assume that you run a small business and 30% of your revenue comes from one customer. Perhaps, you run a landscaping business and have a contract for the local hospital, or you have a cleaning business that has a contract for a large assisted living facility.
Most likely, as you have grown your business, you’ve also grown your costs. You’ve hired more employees. You’ve purchased new trucks or vans. You’ve hired an assistant or a bookkeeper.
Now, imagine that one day that customer calls you up and cancels the contract. Perhaps they have a 30-day notice. Or worse, they go bankrupt or get acquired by a competitor -- giving you no time to react. Now what?
Well, to start, your annual revenue will probably drop by 30%. And, because you’ve built the business around your historic estimates of how much revenue you’ll make in a year, you’re probably now running your business at a loss. Each day that goes by will represent more money going out than coming in. The only way forward is to quickly sign clients to make up the difference, or quickly cut costs (e.g., laying off employees, stopping marketing, etc).
How much customer concentration is too much?
Customer concentration is really a spectrum. For some industries, such as restaurants and bars, customer concentration isn’t an issue at all. Other industries, such as manufacturing or wholesaling, may have higher customer concentration by their very natures.
Generally, the rule of thumb is that you do not want any one customer to account for more than 15% of your revenue, and you do not want your top five customers to account for more than 25% of your revenue.
However, these benchmarks vary heavily by industry.
How can you avoid too much customer concentration?
The first step is to be aware. Savvy business owners keep a finger on the pulse of how much customer concentration their revenue contains.
The second step is to be proactive. The best approach is to proactively diversify your revenue base. Feel like one customer is accounting for too much of sales? Actively work on building relationships with and closing additional customers.
The third step is to be mindful of contracts. If customer concentration is common in your industry, or you landed a huge contract that you cannot turn down, make sure to have your attorney help you negotiate the terms. By making contracts long-term commitments and including long termination notice requirements, you can build in a buffer of time, should you lose a large customer and need to quickly find more work.
How to navigate customer concentration in a business acquisition?
In small business acquisitions, some businesses may have quite a lot of customer concentration. Sometimes, this stumps SMB buyers. At Beacon, we have two recommendations for buyers and sellers of small businesses with high customer concentration.
First, chat with a few banks. Some banks have hard and fast rules on the maximum customer concentration that they will allow. Others are more lenient in their approach. Chatting with banks will help both the buyer and seller understand whether a buyer can get a loan and what deal structure a bank will approve.
Second, structure the deal to align incentives. If a business has 100% customer concentration, a sizable seller note or earn out may be in order. After all, if the business is priced at $1M based on earnings, but a key customer churns 30-days after the sale for a reason outside of the buyer’s control, it’s unfair for the buyer to be on the hook for a business that practically no longer exists.
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If you're interested in acquiring a Main Street business, Katie is your go-to person. Katie hails from Kansas City originally and majored in Art History at the University of Kansas. In her free time, she enjoys climbing, paddleboarding, and cooking.
Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.