Holly founded ExitPromise.com as well as StartupPromise.com and so far has answered more than 3,000 questions asked by business owners about starting, growing and selling a business.
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Business owners should be aware of the relative size of their top customers (or clients) sales revenue to their business’ total revenue.
All it takes is a simple division computation to reveal a customer’s relative size in terms of gross revenue. If calculated properly, a customer concentration may be confirmed.
The business may have a customer concentration risk if one or more of its customer’s total revenue for the year represents 8% or more of all its customers’ revenue for the same year. To many business owners, this concept may sound counter intuitive.
For many feel the more business done with one customer the better.
While it is generally good for customers to increase their purchases of goods and services with a business, unless the remaining customers do so in similar fashion, the growing concentration of revenue from one (or more) customer(s) creates risk for the business owner.
How to calculate customer concentration
- Divide the revenue from your top customer for the last twelve months (or calendar year) by the total gross revenue of your business for the last twelve months (or calendar year).
- If this amount from 1 above is less than eight percent (0.08), you do not have a customer concentration risk. You can relax!
- If this amount is equal to or greater than eight percent (0.08), you have a customer concentration risk with this customer.
- Repeat the calculation with each of your customers using their gross revenue one-by-one from the greatest to least gross revenue in a given year until the calculation is less than eight percent (0.08).
- Every customer with gross revenue which exceeds eight percent (0.08) of your business’ total gross revenue represents a customer concentration risk for your business.
Business owners should also look at the top customers/clients that represent the majority of its revenue to determine if there is an industry concentration. If more than 25 % of a business’ income comes from a single industry, this can be problematic as well.
Should that industry fall into hard times or out of favor, the business could suffer. And that’s true even if no single customer represents a large portion of the business’ revenue.
Determining if a customer concentration and industry concentration exists in a business is an important part of the exit planning process for one very simple reason. When selling a business, the savvy business buyer will determine if one or more customer or industry concentration risks exists and if so, they will most likely reduce their offer price or possibly walk away altogether.
Learn more about how to manage the risks associated with customer concentration.
I am looking at a company to purchase where 2 separate customers
are about 40% each of the total revenue. Is there a rule of thumb to deduct off the normal valuation of business for this level of customer concentration.
Todd,
As a Business Broker, I have represented both buyers and sellers in a transaction in which the business had one or a few customers that generated the majority of the company’s revenue. When a formal business valuation was performed, each case was treated differently as there are no rules of thumb. You should ask the seller how the customer concentration issue impacted the valuation. Also, outside of the valuation, consider the following.
– Does the business have long term contracts in place with these customers?
– How long is the term of the relationship with these customers?
– Is the revenue from these customers increasing with the business, or is it trending down.
– In due diligence, would the business owner allow you to meet the customers. This is unusual before a sale is closed, but sometimes a seller is willing to do this if it is critical.
– Ask the business owner how they propose to help you maintain the customer relationships after the closing. There needs to be a transition plan to reduce the risk of losing a customer.
– An earn-out will eliminate most or all of the risk as it means the seller receives some potion of the payment for the business if these customers stay with you after the closing. An earn-out can range from a period of months to a few years if necessary.
I hope these ideas are helpful. Let me know if I can be of further assistance.
Hi Todd,
I just love this question because the situation you are facing as the prospective buyer is quite common and often the business owner, who is trying to sell his/her business, does not understand why customer concentration is such a big deal!
Unfortunately, there isn’t a rule of thumb associated with customer concentration to discount the asking price. However, if the business valuation was done properly, the fact that this high customer concentration exists should have been taken into consideration.
I’m not sure if you have a formal fair market valuation in hand or not.
If you have a FMV, ask the professional who prepared it for you to tell you how much the high customer concentration percentage affected the asking price.
If you simply have an asking price, then you should consider what the business would be worth to you if one of the two customers disappeared after the sale… and then if they both disappeared.
It very well may be the case that if one or both customers disappeared after the sale, the business may be worthless. What I am suggesting here is not always the case.
You may want to consider the inclusion of an earn out agreement to address this risk. Often using an earn out can address certain risks to the buyer and permit the business to be successfully sold.
All the best to you Todd…