The Perils of Customer Concentration

Recently, I had a conversation with a prospect.?He bought a small Federal government contractor (about $15MM in revenue) with a handful of contracts from just a few agencies. It was 100% debt-financed and had no owner financing.?The?owner personally guaranteed $2MM of?the?debt.?

The?business lost one of its contracts through no fault of its own (he was a subcontractor and?the?Prime botched things up). Unfortunately, that one lost contract had much higher margins than?the?other contracts — much of it covered?the?company’s overhead expense. He immediately cut all direct costs associated with this contract.?

His dilemma, however, was that if he cut overhead, he could tread water and pay debt service costs, but he wouldn’t be able to win new business. That’s because?when Federal contractors bid, they must demonstrate?the?capability to take on?the?contract?including?overhead functions and financing.

Aside from way too much leverage, this company suffered from too much customer concentration. And while it’s true?the?Federal government always pays — there is no payment risk —?the?government can and does?cancel?contracts. Worst of all for this company is that it was very concentrated where its gross margin dollars came from.

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 this??Because companies with high customer concentration have a higher cost of capital?— especially 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 as they will for more diversified businesses.

Why is?the?cost of capital higher?

Because there is more risk to?the?lender.?As in?the?example above, changes in just one or two customer relationships can have a big impact on a customer concentrated company’s ability to pay back a loan and generate returns for shareholders.

What matters most in these cases 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; that squeeze increases?the?risk?the?loan will default. Lenders want to be compensated for this increased risk, so they charge more.

Equity investors want to be paid more for this risk too.?And reduced cash flow to pay back lenders means less cash flow that can be distributed to equity investors or reinvested in?the?company. Remember that most lenders expect to get paid back from?the?cash flow of?the?company — they don’t want to force a sale of?the?company or liquidate assets to get paid. That is why most loans have some form of?Fixed Charge Coverage Ratio?to trigger a default when getting paid back by cash flow is at risk.?

When lenders can’t get paid back by cash flow, they try to sell?the?company (they get paid first).?But lower cash flow reduces?the?value of?the?company.?As a last resort, as a way to get paid if things head south, lenders look at collateral, accounts receivable, inventory, and so forth. Customer concentration increases?the?risk?the?collateral can't pay back?the?loan if needed.

For example, if there is a major dispute with a large customer, you can forget about readily collecting from that customer.?The?same applies with 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.

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.?The?solutions break out along?the?lines of?the?two reasons lenders charge more for customer concentration: cash flow risk and collateral risk…

Mitigating Cash Flow Risk

Mitigating cash flow risk from large customers is difficult and limited in options. Basically, there are two ways to go.

First, deepen your relationship with that large customer.?By increasing?the?number of points of contact that customer has with your company, you are less vulnerable if, for example, a salesperson leaves and tries to take?the?account.?

When I was in?the?Foodservice business, where top salespeople were 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.

Mitigating Collateral Risk

First, talk to your lender.?Depending on?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 that just because a company is very creditworthy, it still doesn't mean there isn't risk they won't pay. Disputes 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, making?the?lender more willing to accommodate this situation.

Large customer credit risk can be mitigated with credit insurance.?Technically, this risk is transferred —?the?insurance pays 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,?the?company files for bankruptcy, etc. And credit insurance doesn't pay when?the?customer?won't?pay due to a dispute.

Another solution is to bring 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. 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: a personal guarantee for a small company,?the?guarantee of another entity, a letter of credit, etc.

Note that none of these solutions are free — customer concentration is costly.

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.

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Charlie Goodrich is Founder and Principal of?Goodrich & Associates, a management consulting firm that specializes in helping its business clients solve urgent liquidity problems. He holds an MBA in Finance from the University of Chicago and a Bachelor's Degree in Economics from the University of Virginia and has over 30 years' experience in this area.