Imagine if you had only one customer. Make no mistake, it would have to be a big customer to keep your business busy. But with only one customer, you’d have only one income stream. And you’d be extremely watchful of that customer’s purchasing behavior, because your entire business would be dependent on them. Everything that happened to that customer, good or bad, would happen to you.
So, why not spread the risk?
Of course, that’s exactly what you do in your business today, by selling to hundreds, if not thousands, of customers each month. By doing so you lower the chances that a catastrophic failure of any one customer would have a catastrophic effect on your business.
This example of having just one customer is just to make a point: You don’t want to have too much customer concentration among your biggest customers, especially if the collapse of just a few of them would mean the failure for your entire company.
If you ever seek an acquirer, the informational memorandum that your investment banker produces to take your company to market will have a section that reveals your Customer Concentration. It’s a crucial and telling section of the Informational Memorandum, because every potential acquirer will want to see how much of your business would drop away if you lost a few of your biggest buyers.
Is heavy concentration at the top really a bad thing? Not necessarily, if those top customers are stable and pay on time. You’d probably be surprised to see how many companies have as much as 40 percent or more of their business concentrated in a dozen customers. In fact, if you’re lucky, some large customers can actually be less-costly to serve, and it’s a benefit to do a great deal of business with them. They often have the technology (e.g. mobile portals for managing purchase orders) to smooth out delivery and payment schedules. Plus, your invoicing might be simpler when you are sending a superbill to a national-grade accounting department, with a strong cash position and a seven-figure credit line. High-quality receivables from large buyers can be an asset, not a liability…until there is too much concentration in too few accounts. That might make an acquirer a little nervous, generating a request for more detail about the nature of the customers you are dealing with at that level. (As a rule of thumb: No one customer should represent more than 10 percent of your business.)
Discounting at the Top
In addition to looking at customer concentration among your top customers, a potential acquirer will also want to see the gross profit margin (GPM) for each of those customers. Their interest in the GPMs is more than just idle curiosity. The acquirer wants to know if you are heavily discounting to your high-volume buyers. If you are, that’s a source for some worry, because you may be delivering large volumes of product at very low margins, a scenario that would ding your company valuation.
However, if your GPMs are around the same as the GPMs you are achieving from your other customers, that shows you run a tight shop, and that you’ve stuck to your guns when negotiating price, even with your high-volume purchasers. That’s one sure sign of a well-run business.
If you have not calculated your customer concentration, it would be an instructive exercise to engage in today. Calculate your GPMs while you are at it, and compare those to the GPMs of your smallest customers to see how they stack up by comparison. If you are preparing to sell your company, make adjustments now, as far as you can. Then, when you are finally ready to show your books to a potential acquirer, you’ll have the data to readily put their concerns about customer concentration to rest.
John Wagner is a managing director at 1St West Mergers and Acquisitions, which offers a specialty practice in the industrial distribution and software sectors. Learn more: www.1StWestMA.com. Contact John Wagner at firstname.lastname@example.org or 919-796-9984.