Customer Concentration: Good, Bad or Ugly?

Why Relying on a Few Major Customers Might Not Be the Risk You Think It Is

Executive Summary

Customer concentration is not automatically a valuation killer. While concentrated customer bases increase certain risks, they can also generate operating efficiencies, predictable cash flows, and symbiotic relationships that enhance business value. The key is understanding when customer concentration is good versus when it is genuinely problematic.

If 10% or more of your revenue comes from a single customer, conventional wisdom says you have a problem. Most business valuation professionals view customer concentration as a red flag that increases risk and diminishes value. But new research suggests this assumption is not always correct.

Understanding Customer Concentration

Customer concentration typically means 10% or more of revenue from a single customer, or 25% or more from the top five customers. For smaller privately held companies, this is remarkably common and can be measured in both revenue and earnings margins.

Traditional theory treats this as problematic. If your major customer becomes distressed, switches suppliers, or brings production in-house, you face substantial revenue loss and receivables risk. However, customer concentration deserves nuanced examination rather than automatic condemnation.

The Upside of Customer Concentration

Research shows customer concentration can promote operating efficiencies. Companies serving major customers make customer-specific investments that yield economies of scale. These relationships foster information sharing, streamlined production, and enhanced working capital management.

Research by Panos Patatoukas at UC Berkeley found positive associations between customer concentration and earnings returns. Efficiencies accrue through reduced operating expenses and enhanced asset utilization. Businesses with stable major customers see increased demand reliability, higher receivable turns, and reduced delivery costs, resulting in higher margins and consistent cash flow.

Consider an electronics manufacturer with 65% revenue from a single customer located next door. The relationship featured long history, weekly meetings, long-term contracts, and consistent future demand. The company maintained above-industry earnings and relied on four key employees, not just the owner. This stable relationship enhanced value through predictable cash flows and operational efficiency.

When Customer Concentration Becomes Problematic

Not all customer concentration creates value. Warning signs include newly established firms with recent large customers, inelastic costs, demand uncertainty, and key customers facing financial distress.

A paint manufacturer experienced surging demand from a large retailer, investing in new equipment to accommodate growth. At valuation, this retailer represented 80% of revenue. Three months later, a new purchasing agent demanded price cuts or threatened to seek alternatives. The company accepted, and historical 15% margins collapsed to less than 2%. When delivering commodity items to cost-conscious customers, contractual assurances are essential.

What the Research Shows

A study of smaller publicly traded manufacturing companies examined whether customer concentration affects equity value. The research focused on profitable companies with $200 million to $1 billion market capitalizations that disclosed customer concentration as a risk factor.

Companies with significant concentration (15% to 30% from one customer, or 40% to 80% from top three) showed higher net operating margins and slightly higher return on equity. They also showed slightly lower quick ratios and higher price to book ratios, but with greater result variability.

Notably, the study found no statistical correlation between customer concentration and EBITDA multiples, profit margins, revenue growth, or returns. The market does not automatically penalize concentration when fundamentals are strong.

Critical Factors for Valuation

When we encounter customer concentration in valuation, thorough investigation is essential. We examine relationship length, contractual basis, product type (proprietary versus commodity), and the competitive landscape.

Key questions guide analysis: How many competitive suppliers exist? What is customer need for these services? Is the customer financially stable? What are switching costs? How does the company compete on service and delivery versus cost alone?

Relationship foundation matters tremendously. A metal fabricator serving Caterpillar plants with 60% revenue held seven separate blanket purchase orders. The competitive advantage was specialized delivery. Although margins with large customers are typically smaller, the volume and reliability from seven separate orders reduced risk and increased value through sustainable advantage.

We request volumes by revenue, gross margin, and EBITDA for significant customers over recent periods, plus budgets of likely future demand.

Practical Implications

When concentration presents risk, we have several adjustments available: increase beta or company-specific risk premium, reduce growth rates through scenario analysis, lower market multiples, or increase marketability discounts. However, we must avoid double-counting the same risk across multiple adjustments.

For strong relationships with long-standing contracts and no key person reliance, little additional risk premium may be warranted. Positive benefits should be reflected in sustained higher cash flows rather than risk adjustments.

Key Takeaways

Customer concentration is not inherently bad for valuation. The impact depends on specific circumstances including relationship stability, contractual protections, product differentiation, and customer financial strength.

Research shows that concentrated customer bases can increase operating efficiencies, reduce expenses, and enhance asset utilization, potentially increasing value through higher sustainable cash flows.

Warning signs include newly established customer relationships, commodity products with low switching costs, customers facing financial distress, and cost structures that do not benefit from economies of scale.

Strong customer relationships feature long histories, contractual arrangements, multiple personnel connections, proprietary products or services, high customer switching costs, and financially stable customers.

Thorough investigation is essential. Appraisers must understand the relationship depth, competitive landscape, contractual protections, and sustainability of the customer demand before making risk adjustments.

Conclusion

When you encounter customer concentration, resist automatic assumptions about lower value. Investigate the relationship thoroughly. Key customers may create positive benefits through sustained efficiencies, growing margins, and consistent cash flow. As with all valuation questions, the answer depends on specific facts and circumstances. Customer concentration requires careful analysis, not reflexive risk premiums.

Source: Business Valuation Review, Spring 2025