The phrase ‘David and Goliath’ springs to mind when you read this article but I am not sure I can wholly endorse the social media reaction that HMRC are to blame for killing off DataCentred.
Whilst there is no magic number for dictating the ideal percentage of turnover an organisation should apportion to any one client, I think most would agree that 85% is a high-risk strategy in any sector and wider diversification would seem a more comfortable and commercially astute approach.
Leaving the moral taxation argument aside and bypassing the burning question of whether or not a small supplier is continually able to meet the demanding requirements of a large client, let us consider operating with an expanded customer base and the risks of not following this wise tactic.
Operating with a diverse customer portfolio makes you more resilient and profitable, increases your chance of long-term success and enables you to withstand losses when an existing client moves their business elsewhere. If your ultimate intention is to sell your business then potential buyers will be interested in your levels of recurring revenue and client concentration, both important factors in agreeing a sale price and finally, versatility in your customer mix will be a strong indicator of your potential for ongoing growth which will be of interest to any potential buyer.
Operating with a narrow segment of clients often means over-reliance on one or a few big customers and this has serious drawbacks, especially for smaller companies. It is easy to be flattered and exhilarated when a large contract is awarded by a well know corporation to a smaller supplier and there is a degree of relief that this guarantee of sales determines your revenue contribution for many months to come. The problem arises, however, when the large client’s contribution of revenue increases to the point where this confirmation of income starts to become a risky client concentration or, as it appears from this article, a dependency.
From experience, I feel justified in saying that many small businesses make the mistake of chasing revenue rather than profit but it is an easy one to make. Big contracts demand lots of attention and can cause management to take their eye off the profit margin. Large customers are also renowned for delayed payments, making unexpected changes to deliverables and renegotiating contracts, all of which creates a degree of vulnerability to the smaller supplier. Referring back to the sale of business scenario, acquirers and investors will be looking to reduce the valuation when they perceive the degree of concentration is too high and may even be reluctant to pursue a deal, especially if the contract of engagement includes control provisions for the large client.
So how much concentration is too much?
There are no scientific equations or business models that I can refer you to, and in the absence of Stephen Hawkins’ intervention, as with all such questions, the answer is,’ it depends’. A rule of thumb I would suggest a figure around 25% figure as anything higher than this is likely to significantly impact on profit, whereas below this figure there is the likelihood of having the capacity to address or mitigate the risk.
On the subject of mitigation should you know of a business that finds itself with an opportunity to embark on a relationship and engage in a new large contract, which subsequently creates a concentration issue, there are a few key things management can do to try to protect the business:
1.Ensure that a good contract is in place between the customer and the business, providing adequate time should this customer decide to exit the relationship.
2.Try to have variable rather than fixed costs to service the majority of the large customer's work, which whilst potentially more expensive, means that costs can be cut more easily if the customer is subsequently lost.
3.Look for leverage with the customer, which makes it more attractive for them to keep their business with you. This may be offering a unique product, providing outstanding customer service, or perhaps exploring giving the customer some interest in your business.
4.Consider trading the high concentration customer through a separate legal entity so that the impact of any loss of that business is contained within the separate company.