Customer Concentration... Something Your Business Should Avoid
To begin with, exactly what is "customer concentration?" Simply put, it's when your sales are concentrated in a few accounts.
Everyone has their own definition, but typically, whenever any one customer accounts for more than 10% of total sales, or when the top five customers make up more than 25% of total sales, a business is said to have customer concentration.
Why avoid customer concentration? Because companies with high customer concentration have a higher cost of capital - particularly for debt, but also for equity.
To make the situation worse, because of the higher cost of capital, companies with customer concentration sell for less. Buyers won't pay the same EBITDA multiple for businesses with customer concentration as they would for similar businesses with a diversified customer base.
Why is the cost of capital higher?
That is because changes in just one or two customer relationships can have a big impact on the ability of the company to pay back a lender and generate returns for shareholders.
What matters most from customer concentration is the concentration of variable contribution, the cash flow that covers overhead. Sales is a proxy for that. Most companies will at least feel squeezed if they lose 10% of their contribution and that squeeze increases the risk the loan defaults. Lenders want to be compensated for this increased risk, so they charge more.
Less cash flow to pay back lenders means less cash flow that can be distributed to equity investors or reinvested in the company. Equity investors want to be paid more for this risk too.
For lenders that look at collateral, accounts receivable, inventory, and so forth, customer concentration increases the risk that the collateral can't pay back the loan.
For example, if there is a major dispute with a large customer, you can forget readily collecting from that customer. Same goes for inventory, particularly work in process or finished goods for a particular customer. (Think goods with the customer's label on it.) Here, lenders look at customer concentration in the accounts receivable as well as in general. A large customer with more generous payment terms than other customers can become a large percentage of the receivables. Many conventional lenders simply won't lend against such a large customer and may limit exposure to the customer or otherwise restrict how much they will lend. (See last month's newsletter
for more on this.) What's the solution?
The obvious solution is to get more customers. That means focusing sales on customer acquisition rather than the easier task of getting more business from current customers.
Of course, that is hard to accomplish and takes time. So what to do? The solutions break out along the lines of the two reasons lenders charge more for customer concentration: collateral risk and cash flow risk. Mitigating Collateral Risk
First, talk to your lender. Depending upon the situation, the lender may grant an exception. For example, a client of mine landed a large contract with a Fortune 10 company. My client's lender agreed to make an exception, as the risk of credit default by the company is nil. [Note, however, that just because the company is very creditworthy, it doesn't mean there isn't risk that they won't pay. Customer disputes do happen and the impact is bigger when that customer owes more to the company.]
Also, calculate the percentage of variable contribution from this large customer. That percentage is likely less than you think due to the lower prices and costlier service levels larger customers often demand. That means there is less cash flow risk to the lender and a lender will be more willing to accommodate such a situation.
Large customer credit risk can be mitigated with credit insurance. (Technically, this risk is transferred.) This insurance will pay when the customer can't. But, the insurance won't pay quickly. It typically only occurs after a judgment has been obtained and all subsequent creditor remedies fail, or the company files for bankruptcy, etc. Credit insurance doesn't pay when the customer won't pay due to a dispute.
Bringing in a special lender - either a factor that buys the specific receivables from the large customer, or a lender that will take a junior lien on the collateral and rely in part on these large customers upon whose A/R the Senior lender hasn't advanced funds - is another solution. Interestingly, factors will often take out credit insurance on specific account debtors to mitigate their own risk. Other factors and junior lien lenders specialize in a particular industry and know the risk of the particular account debtors very well.
One final way to mitigate credit risk from large customers is to have them provide additional security, be it a personal guarantee for a small company or perhaps the guarantee of another entity, or a letter of credit, etc.
Note that none of these solutions are free - customer concentration is costly.
Mitigating Cash Flow Risk
Mitigating the risk to cash flow from large customers is much harder and more limited in options. Basically, there are two ways to go.
First, deepen your relationship with that large customer. Increase the number of points of contact that customer has with your company, so you are less vulnerable if, for example, a salesman leaves and tries to take the account.
When I was in the Foodservice business, where top salesmen where often paid to jump ship, we always made sure there was a dedicated customer service rep and (typically) the same delivery man. Mid-level sales managers visited these customers often. This approach has the added benefit of increasing your understanding of the customer, allowing you to better serve them and, therefore, decreasing the risk of losing them.
The other way to mitigate the risk of losing a large customer is by contract, allowing you to anticipate problems and situations and agree on how they will be dealt with.
A contract can mitigate risk in other ways, too. For example, the customer might own the plant and equipment and you just operate the equipment. In Boston, a government agency owns the commuter rail system, but they hire a company to operate it. Instead of the company investing in track, rolling stock and stations - and risking a loss of those assets if they lose the customer - they just operate the trains on equipment and property owned by the government authority. This mitigates the risk for both parties. Of course, the devil is in the details of a lengthy contract.
In short, customer concentration is best managed by avoiding it entirely. When this is not an option, and as problems arise, these solutions can be brought to bear.