Customer concentration risk is one of the most common hidden problems in a small business sale. If a few customers account for a large share of revenue, losing even one could change the company overnight. Buyers should look for it early, and sellers should be ready to explain it.
What customer concentration risk is
A business has concentration risk when a small number of customers provide a large percentage of its sales. The same idea can apply to suppliers, products, or employees. The danger is dependence: if a key customer leaves, reduces orders, or demands lower prices, profit can drop sharply.
There is no single threshold that defines a dangerous level. What matters is how easily the business could replace the revenue.
How to measure it
Ask for a list of customers with sales by year, and calculate each one’s share of total revenue. Review how long they have been customers and whether they have contracts.
- Share of revenue from the largest customer and the top five
- Length of relationships and contract terms
- Whether the owner personally manages the relationship
- History of price changes or lost accounts
- Payment behavior and any disputes
Questions to ask the seller
Be direct, and listen to how the seller answers. Why do these customers buy? What would make them leave? Have they been told about the sale? Would they continue with a new owner? Honest, specific answers suggest the relationship is strong.
If the seller avoids the topic or says it is not a concern, ask for proof.
How to reduce the risk in a deal
A buyer can build protection into the agreement. Options include a lower price, a longer seller transition period, an earnout agreement that ties part of the price to retaining key customers, or a requirement to meet major customers before closing.
Your lender may also ask about concentration. Review requirements if you plan to use an SBA loan.
What sellers can do
Sellers can improve their position by spreading sales across more customers, signing longer agreements, and documenting relationships. Reducing dependence on the owner helps too, as discussed in the Built to Sell book. A business with a broader base is usually easier to sell and may command a better price.
Take customer concentration risk seriously
Add it to your due diligence checklist, and review it with your advisors. Our guides on buying and selling a business opportunity and business valuation mistakes show where it fits in the bigger picture. Understanding customer concentration risk before you sign can save you from a painful surprise afterward.
More reading on customer concentration risk and deal terms
- Letter of Intent for a Business Purchase: What It Should Say
- Built to Sell Book: Lessons for Owners Planning an Exit
- How to Find a Business for Sale: Where to Look First
- How to Buy an Existing Business: A Due Diligence Guide
- How to Value a Business Before You Buy: Multiples and Seller’s Discretionary Earnings
- Working With a Business Broker: How to Find One and What It Costs
- SBA guide to planning your business
Further reading: Duke Fuqua School of Business.
Keep reading
If this topic is useful to you, these related guides on SmartBizOpps are a good next step.
