Article originally published in the American City Business Journals August 31, 2020.
One of the many risks a business faces is customer concentration. In general, if a large customer represents more than 10% of revenues, the business is exposed to customer concentration risk.
However, this is not a hard-and-fast rule. It depends on how impactful the loss of that large customer would be to the company. The loss of a large high-dollar-margin customer has a higher adverse impact on the company than the loss of a large low-dollar-margin customer.
There are advantages to being a provider to a large customer. The addition of a large customer provides an immediate boost to revenues and earnings, compared with the longer process of adding smaller customers one at a time.
The selling, general and administrative costs of dealing with a large customer are less than those dealing with many small customers. Large customers provide a base load to a manufacturing facility or a regional/foreign office, which permits the addition of smaller customers not of sufficient size to support such a facility. However, do the benefits outweigh the risks?
The more capital that is deployed or committed to long-term expense to provide products or services to a large customer, the higher the risk. This is because capital investment and expense obligations may need to be written off the books if the product or service is no longer purchased by the customer.
In addition to customer concentration, a business also faces the risk of end-use market concentration. If an end-use market supplied by the company is affected by a decline in customer demand, there will be an adverse impact on the firm.
In the process of selling a company, potential acquirers will do a SWOT analysis (strengths, weaknesses, opportunities and threats) on the company and perform due diligence on the customers and the end-use markets that the company supplies. High-customer and end-use concentration will be viewed as a risk factor and will impact the EBITDA (earnings before interest, taxes, depreciation, and amortization) multiple that the acquirer will be willing to pay for the company. The higher the perceived risk, the less they will be willing to pay.
Large customers may use their purchasing power to extract concessions from a provider where that customer represents a high percentage of that provider’s revenues, especially if that customer has alternatives. This describes the situation I once faced as a senior executive of my company.
A large customer in the U.S. didn’t like the price we were charging them for a product. One of their European suppliers committed to building a manufacturing plant in the U.S. to supply them and to charge a price significantly below the price my company charged.
The sale of this product to this large customer represented more than one third of our company’s earnings. We had built two manufacturing plants to supply the customer under a contract that initially protected the product’s selling price. As soon as that contract concluded, the customer demanded a significant price concession.
If we lost the business, we would need to take a very significant write down of the two manufacturing plants supplying the customer. Therefore, we negotiated a much lower price with the customer and kept the business. We also significantly reduced costs to help offset the loss in earnings. The customer certainly leveraged their power over us.
What did I learn from this experience? Never invest significant capital dollars in a manufacturing plant to produce a product for a customer without strong contractual protections, which fortunately we had for the term of the contract. When the contract term concludes, be prepared for the customer to use leverage to negotiate a lower price.
If you are selling to a large customer, it is critically important that you diversify the customer base by also selling to many small customers in many different end-use markets. If you have the opportunity to sell to a large customer, be prepared for the day when you may lose that customer and need to replace them with another source of revenue and EBITDA.
So, do the benefits of selling to a large customer that represents a large percentage of your revenues outweigh the risks? Yes, if you know what those risks are and how you would proceed if you eventually lose their business.
Stan Silverman is founder and CEO of Silverman Leadership and author of “Be Different! The Key to Business and Career Success.” He is also a speaker, advisor and widely read nationally syndicated columnist on leadership, entrepreneurship and corporate governance. He can be reached at Stan@SilvermanLeadership.com.