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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 thr
ough 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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