Evaluating Customer Concentration When Buying a Business
Imagine you own a cleaning company and are considering acquiring another cleaning company as an easy way to expand your customer base. But after inspecting their financials during preliminary due diligence, you discover that the majority of their total revenue comes from a single customer, with the rest from a small handful of customer accounts.
As a business owner, purchasing a company with a concentrated customer base can be risky. If the single client that drives most of the revenue gets nervous about a new owner taking over and cancels their contract, you’ve just spent money on new customers you most likely could have acquired on your own.
Although there are several aspects to investigate when buying a business, such as financial performance and customer relationships, client concentration should be high on your list of things to look out for.
What Is Customer Concentration Risk?
Customer concentration risk measures how much a business's revenue depends on a limited number of customers, indicating the risk of losing one or more of these key clients.
If a business’s revenue base comes from a small group of customers, it’s considered a high concentration risk. A company that relies on one or two key customers could experience disaster if they lose one—much like the cleaning company example above.
Businesses can take action to mitigate these risks by expanding their customer base to reduce reliance on a few major clients. This is known as customer diversification. By targeting a broader range of customers, a business can spread its risk and avoid dependence on a small number of clients.
A general rule of thumb is that no single customer should constitute more than 10% of a company’s revenues. This suggests that if a business you are considering purchasing relies on one to three large customers for cash flow, your client base could churn even with long-term contracts.
Impact of Customer Concentration on Business Valuation
Small business owners have a deep understanding of their company’s value based on factors such as financial performance, market position, and growth potential. However, when it comes to attracting buyers, a professional valuation can provide an objective perspective and help support the asking price. Ultimately, the market will determine the business’s value based on what buyers are willing to pay, which can be influenced by a variety of factors, including customer concentration.
One of the primary factors that can predict a business’s worth is its cash flow. A strong, consistent cash flow is an attractive feature for potential buyers, as it demonstrates the business’s financial health and the ability to generate profits. However, cash flow is not the only factor to consider when valuing a business.
Customer concentration is another crucial element that can influence a buyer’s decision. A high level of customer concentration, where a significant portion of the business’s revenue comes from a limited number of clients, can be seen as a risk factor. On the other hand, a diverse customer base can be a valuable asset, indicating a more stable and resilient business.
When evaluating a business for purchase, consider the following impacts of customer concentration on its valuation:
1. Factors Influencing Business Valuation
- Cash Flow: A business’s cash flow is a primary driver of its value. Healthy, consistent cash flow indicates a strong financial foundation and can make a business more attractive to potential buyers.
- Customer Concentration: The level of customer concentration, or the degree to which a business relies on a limited number of clients for its revenue, can significantly impact its value. A high concentration can be seen as a risk factor, while a diverse customer base is generally more desirable.
- Industry/Sector: The industry or sector in which a business operates can also influence its valuation. The impact of customer concentration can vary depending on the industry:
- Restaurants/Bars: In these industries, customer concentration is typically less of an issue because the customer base is usually broad and diversified. One lost customer has little financial impact since they contribute relatively little to revenue.
- Manufacturing/Wholesale: Businesses in these sectors often experience higher customer concentration risks. They may rely on a few large clients for the bulk of their orders. The loss of one customer can be devastating.
- Specialized Industries: In sectors with only a few potential clients (e.g., aerospace, defense contracting), businesses often have little choice but to operate with high customer concentration. Strategies to mitigate risk, such as long-term contracts or diversifying products or services, are critical.
2. Risks of High Customer Concentration
- Volatility: When a business relies heavily on a few key customers, losing one of the customers can lead to significant fluctuations in revenue and profit. This volatility can make the business appear less stable and, therefore, less valuable.
- Bargaining Power: Large customers that account for a significant portion of a business’s revenue may have greater bargaining power. They could potentially demand lower prices, better terms, or additional services, which can impact the business's margins and overall profitability.
- Investor Perception: Investors, including lenders and potential buyers, may view a business with high customer concentration as riskier. This perception can lead to lower valuations, less favorable financing terms, or difficulty in attracting investors.
3. Benefits of a Diverse Customer Base
- Resilience: A business with a diverse customer base is generally more resilient to economic downturns or industry-specific challenges. If one customer or market segment experiences a decline, the business can rely on other customers to maintain its revenue.
- Growth Potential: Having a broad customer base suggests that a business's products or services have wide appeal. This can indicate strong potential for growth as the business can tap into new markets or expand its reach within existing ones.
- Market Confidence: When a business has a diverse customer base, it can demonstrate that it has earned the confidence of a wide range of clients. This can enhance its reputation and brand value, making it more attractive to potential buyers or investors.
How Does Customer Concentration Impact Financing?
If you plan to buy a business with a high customer concentration, you may have difficulty securing funding. Lenders and investors look closely at a company's customer base during the evaluation process for loans or investments because high revenue from a few customers raises a red flag.
Here’s how lenders may view a business with high customer concentration and how they might respond:
- They fear that losing just one major customer could severely impact the business's ability to repay a loan.
- Lenders might offer loans with higher interest rates or less favorable terms due to the perceived higher risk.
- Mergers and acquisitions might value businesses with high customer concentration lower because of the perceived higher operational and financial risk.
How to Address Customer Concentration When Buying a Business
While gut instincts are valid when buying a business, there are ways to structure the purchase deal to address customer concentration.
It involves strategic planning and crafty negotiations to reduce your risk as the buyer.
Here’s how to structure deals effectively in situations with high customer concentration:
- Earn-Out Agreements: Part of the purchase price is paid out based on the business's future performance. If the company maintains its major customers or diversifies successfully, you pay the total cost over time.
- Seller Financing: Involves using credit from the current owner to complete the purchase, often using the business itself as collateral.
- Retained Equity or Consultant Role: The seller retains a minority equity stake in the business or agrees to stay in a consultant role for a period post-sale. This ensures they have a continued interest in maintaining key customer relationships.
- Warranty Insurance: This insurance covers the buyer for losses due to the seller’s breach of representations and warranties.
- Structured Payments: Payments are structured over time and tied to specific performance milestones, such as retaining key customers.
- Due Diligence: Focus on customer contracts, satisfaction levels, and the historical stability of customer relationships can give the buyer a clearer picture of the risk involved.
- Customer Retention Plan: Developing a customer retention plan as part of the deal can help address concerns about customers jumping ship once the deal goes through.
The Value of Professionals When Buying and Selling a Business
There’s no denying that buying or selling a business is a lot of work. There are relationships to navigate, financials and balance sheets to make sense of, financing to secure if you don’t have cash on hand, and the future health of the business to consider.
Business brokers are adept at evaluating the risks associated with customer concentration, using tools and methods to analyze financial data, assess the stability of key customer relationships, and project future revenue streams.
In addition, they can provide a deeper understanding of the potential impact on valuation and financing options, which is beyond the reach of some business owners. Most importantly, professionals provide an objective perspective free from any emotional attachments.
Enlisting the help of a professional can make the difference between a deal that flourishes and one that flounders. When buying a business, carefully consider customer concentration risk and its potential impacts on valuation, financing, and long-term success. Visit BizBuySell’s Broker Directory to find a professional who can provide expert guidance to navigate business transactions.