There are a variety of factors that contribute to the value of a business and influence its ultimate selling price or valuation. One of the most significant is customer concentration. How do you know if your customer concentration is high or low? A rule of thumb holds if any single customer accounts for more than 15% (some buyers believe 10%) of your annual revenue – or if your largest three customers account for 30% or more of annual revenue, you have high customer concentration. A diverse customer base means your revenue comes from many clients or customers, not just two or three, and preferably comes from multiple sources other than your primary service.
In general, having one customer dominate much of the annual sales presents increased risks and will lower the enterprise value. Why? Because it reduces the risk of serious cash flow issues if one or more customers do not stay under new ownership.
For smaller businesses (less than $25 million in annual revenue) the main challenge is size. A few sales to one customer can quickly escalate and become a large portion of sales. Customer concentration can sneak up on CEOs because the issue often develops when everything is going well between you and your customer.
As a growing company what can you do to maintain a diversified customer base?
- Understand Your Customer Base through Reporting. Reports to analyze include:
- Revenue by Customer: A quick insight into the diversity of your customer base is to run a “gross-revenue-by-customer-report-by-year.” It will show you the percentage of total revenue each of your customers generate year by year.
- Customer by Geography: What geographical area do you serve? Are your customers mostly local, regional, international? Use pie charts or heat maps to display the data.
- Customer by Channel: Breakdown your customer base by channel (channels may include direct business via your online website, your firm’s in-store sales, wholesale, online wholesale, and so on). Again, use pie charts to show the percentage breakdowns.
- Accounts Receivable Aging: Pay attention to your accounts receivable and aging report because this will indicate if your customers are facing cash flow issues.
- Develop a solid sales strategy that considers several variables.
- Location: Use the data to determine next logical areas to target. If you have a strong presence in a certain location, consider why. Try to replicate your successful model in new locations.
- Channels: Determine what channels you need to grow in the next year. Consider that certain channels may be less profitable to the firm. You still may value having these customers in your customer mix, but be sure your strategy is balanced and allows you to maintain strong/stable EBITDA margins.
- Correctly Analyze your Firm’s Capabilities: Often of the key goals for businesses is to sell to the big customer in your industry, it’s a good long term goal; however, you should spend ample time building your reputation, and your sales with a larger number of smaller customers. It takes practice to make things right. If you mess up with a large account, you may find yourself in a holding pattern to get back in.
- Consider the Size and Reputation of Your Customers: Certain customers targets might be too large for a small firm to take on. You can grow into this customer by targeting smaller firms first. Also, consider the reputation of firms. Not all customers are good customers. Part of your strategy should to be identify which customers fit with your firm. After they are identified as a good fit, perform background research to understand if they are a quality customer.
- Develop Solid Customer Contracts. Understand what standard industry terms are for each of the various channels. Set standards for your firm that allow you to keep your profitably up.
Developing a sales plan is hard work. Much of the work is in research and planning rather than in acquiring the new customers. A solid sales plan will allow a company to be in control of its own destiny, influence what types of customers it works with, and shape what it’s business is about. Ultimately, if you can maintain a diverse customer base while growing your company, your company’s valuation will be higher when you exit the business.