03 May How Customer Concentration Impacts Value
Customer concentration is a measure of how total revenue is distributed among a company’s customer base. This is calculated by dividing the individual customer sales in a given period by the total company sales in the same period. If a company sells to many customers or revenues are spread out relatively even among customers, it is typically considered to have a low customer concentration. Whereas, if a company sells to a few customers or revenues are relatively concentrated among top customers, it is generally considered to have a high customer concentration. The level of customer concentration correlates directly with the customer concentration risk and naturally, if the risk factor for customer concentration is high, there will be a negative impact on a company’s valuation, as company-specific risk increases.
The following should be considered when examining customer concentration:
- Is it necessary to analyze Customer Concentration?
- Regardless of total customer count, a company’s top customer(s) should be analyzed to determine the relationship between the customer and company. Whenever a single customer makes up 15% or more of a company’s business, it is important to examine the relationship and the subsequent risks related to this customer. It should be noted the 15% is just a guideline. If a company has a small number of overall customers, revenue concentration among top customers should be analyzed even if no single customer accounts for 15% or more of sales. Examples of industries that typically do not have customer concentration include liquor stores, restaurants, convenience stores, retail shops, etc. Industries where companies may have customer concentration include manufacturing, construction, wholesale, distribution, etc. However, this will vary for each specific company depending on its business model.
- What percentage of revenues does the customer account for?
- All else equal, the higher percentage of sales a single customer (or few customers) accounts for, the greater the impact on revenues if this customer were to stop doing business with the company, and ultimately the higher the concentration risk. If a customer consistently accounts for a significant portion of revenues, there is a greater risk than if the company completes large projects annually and the customer for which these projects are completed changes year over year.
- How long has the company been working with the customer?
- A customer that has a long-term relationship with the company is less risky than one who has been a customer for only a short period of time. If the company worked with the customer for one non-recurring year, then it is difficult to determine if this revenue will continue in the future, or if it reflects a one-off revenue source. This usually results in a higher concentration risk. If the company has worked with the customer for numerous years, it is easier for the Appraiser to expect the customer to remain with the company despite a change in ownership, usually lowering the concentration risk.
- Are there any contracts in place with the customer?
- If a large customer has signed a contract with the company, an Appraiser should review the contract in place, if possible. However, even if a contract is not available, important details to consider include:
- Transferability to a new owner
- Guaranteed revenue and exclusivity
- Length of the contract
- Termination clauses
If a transferable contract guarantees revenue or is exclusive to the company, there is limited risk associated with this customer due to the assumed consistency in revenues and the minimal impact from competition. Furthermore, a contract that spans multiple years makes it easier to project revenues going forward. Regardless of the terms of the contract, generally a customer signed to a contract is less risky than a customer with no contract.
- If the company were to lose this customer, how would revenues be replaced?
- If a company operates with a waitlist or is already operating at capacity, which leads to turning down potential customers, it is likely easier to replace revenues lost in a timely manner. However, if lost revenue from a single customer would take months, or even years, to replace, the risk associated with this customer should be higher.
- Impact of Customer Concentration Risk
- Let’s look at two manufacturing companies with different business models, all else equal. Company A has hundreds of customers that order products and parts on a consistent basis. Company B has 20 customers who engage the company for a few large projects per year; none of the customers are signed to long-term contracts, two of them account for a combined 50% of sales, and one of those customers has only been with the company for a single year of operations:
Note: Multiples utilized and impact of risk are for example purposes only
As can be seen above, a higher risk factor related to customer concentration could lead to a lower multiple and value. Therefore, it is important to analyze customer concentration for all different companies and industries as it can have a material impact on a business valuation.