How Customer Concentration Affects Business Value
Customer concentration lowers the value of a business when a few customers produce a large share of its revenue or profit, because losing one of them would change the earnings a buyer is paying for. A valuer measures the share held by the largest customer and the top five over several years, then reflects the risk by testing a loss scenario and by adjusting the multiple or the required return. Concentration does not make a business unsaleable, but it usually makes the price more cautious.
- Measure concentration by profit as well as revenue, and over three years rather than one.
- It is a risk to future earnings, so it never shows on a profit and loss statement.
- Builders, head contractors, facilities managers and government panels are the usual sources in trade businesses.
- A valuer reflects it through a loss scenario and through the multiple or required return, taking care not to count the same risk twice.
- Contract terms, a long relationship and several decision makers at the customer reduce the risk; they do not remove it.
What is customer concentration?
Customer concentration is the share of a business’s revenue or profit that comes from a small number of customers. The more that rests on one or two names, the more the earnings depend on decisions someone else makes.
A count of invoice names is rarely the right unit. Three builders owned by the same group, or several projects run by one procurement manager, behave as one customer if a single decision can end all of the work. A large head contractor, on the other hand, may have many project teams that choose subcontractors independently. We group customers by who decides, not by who is named on the invoice.
How do you measure customer concentration?
Four measures do most of the work, and they are most useful together.
| Measure | What it shows | What we look for |
|---|---|---|
| Largest customer share | How much rests on one decision maker | Share of revenue and of gross profit in each of the last three years |
| Top five share | Whether the risk sits with a small group or a wider base | How quickly the share falls after the first and second customer |
| Trend over three years | Whether concentration is rising, steady or falling | Growth that comes from one customer while the rest of the business is flat |
| Revenue against profit | Whether the biggest customer is also the most or least profitable | Margin on each major customer after direct labour, materials and travel |
Three years is the usual window because a single year can mislead. A customer won partway through the period looks small in a full-year average and large in the latest year, and a one-off project can make an ordinary customer look dominant for twelve months.
The trend matters as much as the level. The table below shows a business whose headline growth hides a rising dependence on one customer.
| Year | Total revenue | Largest customer | Largest customer share | All other customers |
|---|---|---|---|---|
| Year 1 | $2,000,000 | $500,000 | 25% | $1,500,000 |
| Year 2 | $2,200,000 | $770,000 | 35% | $1,430,000 |
| Year 3 | $2,500,000 | $1,000,000 | 40% | $1,500,000 |
All figures are illustrative. Revenue grew by $500,000 over the period and the largest customer accounted for all of it, while the rest of the business stayed close to $1.5 million.
A one-year view of Year 3 shows a business with a large customer. The three-year view shows a business that has become dependent on one.
Where does concentration come from in trade businesses?
A few patterns recur across the trades.
- Builders and head contractors. Subcontractors in plumbing, electrical, concreting, roofing and civil work often earn most of their revenue from two or three builders or head contractors, usually through a relationship with a site supervisor or director. We also consider the builder’s own financial position, because a customer that fails can take unpaid invoices with it.
- Government and council panels. A place on a panel makes a business an eligible supplier. It does not usually commit the agency to any volume of work, so we look at the work actually allocated and at when the panel is next re-let.
- Facilities managers and national maintenance contractors. One facilities management company may sit between the business and many sites. The sites look like many customers, but the decision comes from one.
- Strata and property managers. The owners corporation or landlord signs, but one manager’s portfolio may supply a large share of the work.
- Developers and repeat project clients. The work is lumpy, but one developer’s pipeline can still drive the year.
Our industry pages for electrical, civil contracting and building describe how this shows up in each trade.
Why does concentration change risk and not just earnings?
A profit and loss statement reports what happened. A valuation is about what a buyer can expect to happen next. Concentration does not change last year’s profit, so it never appears in the accounts, yet it changes how reliable that profit is as a guide to the future.
It also changes the balance of power. A customer that supplies a third of revenue can ask for lower rates, longer payment terms or extra service at no charge, and the business has little room to refuse. Those pressures tend to arrive after a sale, once the relationship with the former owner has gone.
The loss is also uneven in time. Revenue leaves at once, but the vehicles, staff and premises that served the customer do not leave at the same speed. We reflect that in the scenario below.
A buyer who funds the purchase with borrowings also faces repayments that continue even if the largest customer leaves, which is one reason buyers price concentration cautiously.
How does a valuer reflect concentration?
There are two tools, and a valuer may use either or both. The first is a scenario: what would the business earn if the largest customer left? The second is the multiple, or the required return, which can be set to reflect that earnings are less secure than they would be with a spread of customers.
The scenario depends on evidence rather than instinct. We ask how the customer awards work, when the current arrangement ends, whether the customer has gone to tender before, how it has treated other subcontractors, and how quickly the business could redeploy the crews and vehicles that served it. Losing a customer is also not always all or nothing: a customer may cut volumes or rates instead of leaving, so a partial reduction can be tested as well as a full loss.
The figures below are illustrative. The 3.0 times and 2.5 times are assumptions chosen to show the arithmetic, not market data.
Illustrative: testing the loss of the largest customer
Illustrative- Maintainable earnings after normalisations
- $400,000
- Revenue from the largest customer
- $1,000,000
- Contribution from that customer at 25% after direct costs
- $250,000
- Overhead that could be removed if the customer left
- $50,000
- Earnings at risk ($250,000 less $50,000)
- $200,000
- Earnings if the customer is lost ($400,000 less $200,000)
- $200,000
- Value with the customer, at 3.0 times
- $1,200,000
- Value without the customer, at the same 3.0 times
- $600,000
- Value resting on that one customer ($1,200,000 less $600,000)
- $600,000
- Alternative: full earnings at a lower 2.5 times
- $1,000,000
- Reduction from $1,200,000 (about 17%)
- $200,000
Every figure is illustrative. The scenario shows how much of the value depends on the customer. It is not a forecast that the customer will leave.
The valuer’s conclusion usually sits between the two ends, and where it sits depends on the evidence for the relationship. A lower multiple than the one used for a business with the same earnings and a spread of customers is one way to reflect it. A weighting of the scenario is another.
Count the risk once
If the earnings have already been reduced for the possible loss of a customer, the multiple should not be reduced again for the same risk. Using both without checking for overlap understates the value, so a report should show which tool carries which part of the risk.
Either way, the adjustment is a documented judgement, not a formula. A report should say which customer, how much of the earnings are at risk, why, and how that moved the conclusion.
What reduces the risk of concentration?
Concentration is a matter of degree, and several things move it up or down.
- Contract terms. Term remaining, renewal history, minimum volumes and no exit on a change of ownership all help. A panel place, or a customer who can end the work on short notice, helps much less. Our guide on recurring maintenance contracts covers what makes a contract worth something.
- Length and history of the relationship. A customer held for many years through several changes of staff is steadier than one won last year.
- Several decision makers at the customer. Where many site managers, project teams or procurement staff rely on the business, losing one contact does not end the work.
- Switching costs. Site knowledge, compliance records, inductions and system integrations make the business harder to replace.
- Customer strength. A financially sound customer with a record of paying on time is a lower risk than a builder with stretched cash flow.
- Margin. If the biggest customer is also the lowest-margin one, less profit is at risk than the revenue suggests.
The mix tends to matter more than any single item. A large customer on a short contract, with one contact and a thin margin, is a different proposition from the same customer on a long agreement with several contacts and a healthy margin.
Where the relationship sits with the owner personally, the risk is higher, because the customer may follow the owner rather than the business. Our guide on valuing a business with owner dependency covers that.
What can an owner do before a valuation?
Spreading a customer base takes months or years, and it cannot be fixed in the weeks before a valuation. What can be done quickly is to gather the evidence.
- Revenue and gross profit by customer for the last three years, grouped by decision maker.
- Copies of agreements, panel deeds and standing orders with the largest customers, including termination and assignment clauses.
- Payment history and any disputes with the largest customers.
- A note of who at the customer places the work and who at the business manages the relationship.
- Any pipeline of new work with other customers, with dates and evidence.
Heavy customer concentration is one of the features that can place a matter within our Complex Valuations scope, which starts from $2,995 + GST. The pricing page explains what that covers, and our guide on preparing a trade business for valuation sets out the wider checklist.
This guide is general information, not legal, taxation or financial advice. Examples are illustrative. The appropriate valuation approach depends on the circumstances and purpose of each engagement.