Client Concentration Problem

What Client Concentration Actually Is

Most business owners know client concentration is a risk. Fewer can tell you what the threshold actually is — or why the percentage is the wrong thing to focus on.

In this episode, Richard McMullan breaks down what client concentration means in practice: where the 15% guideline comes from, why the real threshold depends on your margins and business model, and the single question that cuts through the noise and tells you whether you actually have a problem.

If you're not sure how exposed your business is to your biggest client, this is the place to start.

Transcript

SPEAKER_00 0:02

Many owners have one client they can't afford to lose. The problem is most of them have no idea. Not because they're careless, because when everything is going well, there's genuinely nothing to notice. The client is buying, they're paying on time, they're happy with what they're getting. It doesn't show up in your Monday morning, it doesn't wake you up at night, it just sits there quietly until something changes. Let me take you back a hundred years to share an example. In the earliest 20th century, the United Fruit Company, that's the business that would eventually become Chiquita, built a network of banana plantations across Central America. It also built the roads, the ports, the railways, and in some cases the postal service. Basically everything needed to help their farmers succeed. And governments and the farmers were very grateful, as you might imagine. The relationship felt like a real partnership, a route to prosperity. In Costa Rica alone, United Fruit accounted for 58% of all their exports, and they employed or the employment of one in seven agricultural workers. The company wasn't just a client, it was the client. Which meant that when United Fruit decided to move its purchasing elsewhere or used its scale to dictate prices and payment terms, the countries it dealt with had almost no leverage at all and had to fall in line. That relationship, which felt like an asset, turned out to be a trap. Entire economies had been built around a single buyer's appetite, and that buyer had no obligation to stay hungry. The Central American governments caught in this position weren't necessarily naive or poorly run. They had made rational decisions at every step. The problem wasn't the decisions, it was the structure those decisions created. And unfortunately, I see the same pattern in manufacturing, engineering, and complex B2B businesses. The names might be different, the scale is smaller, but the dynamic is nearly identical. So let's start by defining client concentration. Simplistically, it's when one client makes up too big a proportion of your revenue. The guideline most advisors work to is 15%. If a single client accounts for more than 15% of your sales revenue, that's considered concentration. In practice, depending on your margins, depending on your business model, and depending on your client mix, the real threshold can sit anywhere above 8%. But the percentage alone isn't what matters. The question that truly defines your risk is much simpler than that. If your biggest client stopped buying tomorrow, what would it do to your business? Is it a case of, oh holy shit, we're banjacks, what the hell are we going to do? Or is it a case of that's annoying, but not the end of the world? You know, if it's the former, you've got a client concentration problem. The really strange thing about client concentration though is that when everything is going well, you genuinely don't notice it. There's no obvious red flag. You know, the client is buying on time, they're happy with what you're doing, they're paying on time, you're happy too. There are no obvious issues. It doesn't show up in your day-to-day, it's not a wake you up in the middle of the night type problem. And it's not something most owners think about unless they've stopped and analyzed their numbers. And most don't, because there's no immediate reason to do so. It's a classic. If you don't know, you don't know. And then there's another layer to this that makes it even harder to see clearly. Often that big client is a marquee name, you know, it might be a brand everyone in your market recognizes, and that feels good. It motivates people in the business. You know, we deal with them at Mercedes, or we supply the biggest contractor in the region. And you know, that pride is real and it's not irrational, but it can actively mask the structural risk because the relationship facing an achievement rather than a dependency. Now, why do businesses end up in this position? Well, a bit like the Central American governments, this is something that sneaks up on most owners. It's rarely the result of a bad decision. The most common path starts in the business's early days. The owner finds a client they get on well with, they do excellent work for them, and the relationship grows. That client starts to buy more and then asks for a little more. Can you do this and a bit of that? And the offering expands, sorry, the relationship deepens, and slowly that one client starts to drive a significant proportion of income. That one client starts to drive a significant proportion of income. The truth is, once a client is growing fast enough to fund your growth, the pressure to go out and find new business simply disappears. You don't have to worry about where the next sale is coming from. You don't have to go out and drive demand. There's a client who wants more and you're building alongside them, and that feels like a great place to be. Yeah. Now, the second path involves a sudden leap, if you will. You know, an established business pitches for a significant new client, they win it, and that client immediately accounts for a disproportionate chunk of revenue. You know, I've seen businesses go from eight million to the potential of 30 million within two years because of one new client. It's a fabulous opportunity, and you would be foolish, nay mad to turn it down. But it comes with a structural risk that the excitement of the moment makes very easy to ignore or explain away. In both cases, the decision to take the business made sense. The concentration that followed wasn't a mistake, it was the natural consequence of success. That's what makes it so hard to see this clearly and so easy to leave it unaddressed. But the question you've got to answer for yourself is you know what actually happens if you leave it alone? In my experience, unaddressed client concentration can hurt a lot. At worst, it can put you out of business. And that may sound like scaremongering, but it's not, it's just the harsh reality. And many months ago I just started working with a new client, a solid business, well run, on track to make around 325 grand profit for the year, at roughly 10% margins. During my usual initial analysis, I noticed that one customer accounted for 25% of their revenue. The owners, three family members, were relaxed about it. No, no, it's fine, Richard. They're a fantastic customer. We've been working with them from day one. We know everyone in there, they trust us, we trust them, it's all okay, there's nothing to worry about. A few weeks into the engagement, with no warning at all, the US parent company of that customer, of their customer, issued a global moratorium on purchases. No new invoices, no new purchase orders, live off existing stock, conserve cash, turn work and work in progress into money. In fact, don't buy anything without HQ's permission. That was nearly 25% of my clients' revenue gone overnight. They went from looking at a healthy profit to being loss making at year end. Here's how it looked. Now, these aren't the exact numbers, but the percentages, etc., are consistent. So you can see the 325k profit. Um, you know, from their forecast profit with that client in there, when you strip the client out and look at their contribution, you know, basically take away their cost of goods sold. So that's what they're contributing to the manufacturing labor, to the marketing, the overheads, etc. You can see it's a chunky contribution, and when you ex subtract that from that forecast to get a re-forecast number, you can see the company's getting into a loss of about 124 grand. Painful. Now, these are the key ratios you can see. Two things I want to point out to you here. You can see that the client's cost of goods sold is higher than everyone else's. In fact, because they're at 43% rather than the average of 40.5, you know, without them, it drops to the 39%. So there's nearly one total percentage point of impact they're having on the cost of goods sold because they were getting discounts. So the the business that was left was actually generating more contribution to overheads and direct costs than you know, it's a percentage terms than it was with that big client. Now our work changed immediately from growth strategy focused to saving the business. We restructured the organization, we made 15% of the work face sorry, workforce redundant in the following three months. There was a lot of stress, a lot of difficult conversations, a lot of fear amongst the remaining team. And it was probably a further six months before the business recovered and rebuilt their confidence and got back to where they were. On the upside, though, there's a silver lining to this story. The forced restructure eliminated a lot of overlap between roles and created real clarity around what the business actually did and who it did it for. When the big client came back, and they did come back because of the relationship, my client was in a position to reset the terms. You know, you've been using us for just in time delivery, which means we've been carrying stock on your behalf. We're still happy to do that, but there's a fee for that. We've had to increase our prices because of X, Y, and Z. All delivered courteously, of course, but but clearly with confidence and conviction. That customer returned in better terms and better margins, and in the meantime, the business had gone out and found better fit clients to replace the lost revenue. They ended up in a stronger position before than before, but they had to go through a very painful 12 months to get there. That concentration problem left unaddressed forced the restructuring that should have been done by choice on their terms, on their time scales, and with a lot less pain. Now, at this point in the conversation, most owners say some version of the same thing. Richard, I hear what you're saying, but our relationship with this client is different. We've worked together for years. This doesn't apply to us. Well I understand that, and I say the same thing to them as I said to my client who gets shafted by that US parent company. Things change. The trust may be real, the relationship may be real, there may be 20 years of shared history. The question is never about the relationship to date. It's about what happens if the relation what happens to the relationship if something changes in the customer's business? What if the person you deal with retires or moves on or gets ill? What if the business changes ownership? And the new buyer then comes in with their own preferred supplier? What if a decision gets made three levels above your above your contract by someone who has never heard of you and is looking at a spreadsheet or has different priorities? You cannot rely on past history as a guide to future performance. The risk isn't your existing relationship, the risk is everything outside of that relationship that neither you or they control. And you have to assume at some level and at some stage that something will change. Because in business, something always does. The question is, is what you've built to protect yourself from that when it does. The instinctive response of going out and winning more clients doesn't fix it, I'm afraid. And done without the right preparation, it can actually make things worse. Why is that you ask? Well, when a business has a concentration problem, it usually also has a clarity problem. It hasn't clearly defined who its ideal clients are, it hasn't articulated the value it creates. Not just the practical financial value, but the problems it solves, the stress it takes away, the things it makes easy for clients that would otherwise be a source of grief. It hasn't positioned itself with a clear reason why the right kind of client should pay a premium to work with them versus anyone else. The big client relationship often obscures all of this. The business has been so focused on serving one client well that it hasn't had to answer those questions. So if you just go out and get more clients without doing that work first, you'll attract the wrong ones. And wrong clients make the business more complex, harder to run, and less profitable. You'll have solved your concentration problem and your concentration number on paper while making the underlying business worse. The answer is more clients, but specifically the right clients. And getting there requires defining who they are before you go looking. I've said it before, I'll say it again, you know, the client is buying on time. It's buying, sorry, they're paying on time and there's no stress. And it doesn't feel like a problem because, well, it isn't showing up as one. Whether they're, you know, 1% or 25% of your revenue. But there's a low-level dread that arrives when you become aware of it but haven't done anything about it. You you know, when you know the amount and you know what it would mean if that client cut back on their purchases. It doesn't change your Monday morning as such, but it does lurk in the background. A low-level dread that surfaces when you let yourself think about it. And that's what happens, you know, when you manage it down. That when you're managing it down, that's what it actually removes. Not the client, the dread. When you're actively managing and tracking the concentration, reducing the dependency, and replacing it with better fit revenue, that background noise and dread quiets. Not because the risk from that big client has disappeared overnight, but because you're no longer just hoping nothing changes, you're now actively managing the risk. So if you've recognized yourself somewhere in this conversation or don't know if you've got a concentration problem, in fact, especially if you don't know you have a concentration problem, the first thing to do is get the data in front of you. Not once now, mind, but monthly. Track your top 10 or 20 clients as a percentage of your revenue. A simple chart is enough, and that chart will tell you two things immediately: whether one client is running away from the others and becoming disproportionately important, or whether any are declining sharply. Both are early signals that something needs your attention. Ideally, if your systems allow it, take the next step. Calculate contribution margin by client, like I did earlier, and take their revenue and subtract the direct cost of goods or delivery. That number as a percentage of your total tells you what each client actually contributes to your operating cost, not just your turnover. This is often surprising. Bigger clients are frequently less profitable than smaller ones because of the discounts, the extended terms, the additional service demands you know that come with the relationship. Knowing that number changes your conversation with them and reduces your fear of losing them. The third thing to look at is debtor days by client. What do they owe right now? Excuse me, what do they owe right now and what are they paying within your and are they paying within your agreed terms? Sorry. If one client's payment terms are starting to stretch, even slightly, that's an early signal worth taking seriously. It's often the first sign that the balance of the relationship is shifting.

SPEAKER_01 18:06

Excuse me.

SPEAKER_00 18:06

None of this takes long, but it does make the risk visible, and visible risk is manageable risk. That's crucial to the value of your business because if you ever want to sell or bring in investment or simply know what your business is worth, client concentration is one of the first things a buyer will look at. And it's rarely good news. Most prospective buyers don't like concentration because it poses a direct risk to the revenue they're buying. If one client accounts for 30% of turnover, the buyer's immediate question is, will that still be there after I complete the acquisition? The honest answer is not necessarily. Ownership change prompts clients to reconsider the relationship that client had was with you, with the people they knew, and a new owner changes the dynamic even if everything else stays the same. That uncertainty for the buyer gets priced in, lower valuation, deferred consideration, earnouts that tie your payout to whether that big client stays for another two years. There is a flip side worth knowing about. But it's a narrow, scary, cliff-edge path. It requires real focus and guts to evolve into a genuine strategic supplier for one client. And there's a horrible stage in the middle where it becomes terribly risky when you're not yet seen as the irreplaceable strategic partner, but you have nearly all your eggs in the one basket. As I say, it's a gutsy call, and you must commit and double down in the strategy. Anyhow, for most businesses, the valuation story is simpler. Concentration means a discount and less attractive deal terms. Right. Time to wrap up. Those Central American economies that became dependent on United Fruit didn't set out to become dependent. They followed the logic of what was in front of them. A buyer with capital, infrastructure, and appetite. Each decision in isolation made sense. The structure those decisions created did not. And it's a very human response to opportunity. It's also the response I see from owners who know they have a concentration problem and have decided to live with it. For now, while the client is still buying, while everything is still going well, they decide to hang in there. But the restructuring when it's forced upon them hurts. People lose their jobs, the owner is stressed to the hilt, and it's a battle to get through it. Sadly, some businesses don't get through it. The owners I've helped reduce client concentration by choice, who track the numbers to find the right clients and systematically bring the concentration down before it becomes a crisis, they do it on their own terms, and the process is a lot less painful, costly, and stressful than they first imagined.

SPEAKER_01 21:52

So, do you have a client concentration problem? And if you do, please get to work on it now.

unknown 22:00

Boy.

SPEAKER_01 22:02

You'll thank me in time.