Understanding Customer Concentration Risk

It’s a story that hits home for many ambitious SaaS executives. You’ve worked hard for months at your first startup when finally, your big break comes. You sign a contract with your biggest customer yet - by a long shot. You’re blissfully unaware of the challenges that lie ahead.

Before long, the customer starts making more demands on your resources 😬 . Your team seems to spend all their time servicing this customer, and your smaller accounts are getting antsy. Soon, those smaller accounts begin to churn.

Your large customer becomes aware that they’re indispensable to you. They then leverage this power to bargain against you, forcing your prices further and further downward. Now, the hemorrhage of capital threatens your whole business 📉 .

How did this situation happen? And more importantly, how can it be prevented from happening again? Issues such as these can be mitigated by careful management of customer concentration.

🤨 What is customer concentration and how does it affect my business?

Customer concentration is the percentage of revenue held by your largest customers.

Why does it matter? Put simply, overconcentration of revenue is “putting all your eggs in one basket”. Over-reliance on one client, or a small group of clients, is one of the riskiest business decisions you could make.

The obvious risk with overconcentration is the loss of the oversized customer(s), resulting in devastating revenue loss. There are additional risks as well, some of which we encountered in the story above. These include:

The opportunity for large customers to leverage their power and negotiate prices downward.

The risk of customer loss can force you to focus your resources on retaining your biggest customer(s), neglecting your smaller ones.

Investors see high concentration as risky. They’re far more likely to invest in heavily diversified companies.

What should the aforementioned executives have done? Surely, they shouldn’t have turned down a life-changing deal because it might create overconcentration.

The executives’ mistake came after they closed the deal when they failed to rebalance their customer base. After acquiring the customer, swift attempts to diversify were in order.

🤷🏽 How much customer concentration is too much?

Forbes gives a guideline of no more than 10% of revenue from a single customer. Any higher, and you’re in danger of all of the problems we described above. In fact, Forbes categorizes this as one of the top risks to your business.

In addition to the above 10% rule, your top 5 customers should make up no more than 25% of your revenue.

🧮 How do I calculate my customer concentration risk?

The following calculation refers to revenue from the past 12 months.

If the resulting number is greater than 0.08, you’re at risk for a customer concentration issue.

If the figure is over 0.1, you already have a customer concentration issue.

Additionally, remember to add up the values for your top 5 customers. If the resulting figure is over 0.25, you have a customer concentration issue - even if the individual customers are all in the acceptable range!

🛠 Fixing customer concentration problems and increasing replicability

When you’re ready to hit the market, investors will want to see a reliable business plan. They’ll want to know that you can continue acquiring customers at least as large as the ones you currently have. In other words, they’ll want to see that your business model is replicable.

Consider what it says about your business if the majority of your revenue comes from one huge client, and the minority comes from a mass of smaller ones. It frames your large customer as something of an anomaly, while your smaller clients are the norm.

If your large deals are lucky flukes rather than regular occurrences, investors will seriously question your ability to obtain more of them. When that dilemma is coupled with insufficient revenue from small customers, it tells investors that your business is unsustainable.

So, how do you increase replicability? The basic process involves determining what’s worked for your largest customer, and employing strategies that will help you acquire more customers like them. Here are a few guiding principles:

Prevent the worst customer concentration risks right from the start by aiming for long term contracts. The longer a customer’s commitment to you, the less likely they are to churn.

Whenever possible, ensure that solutions you create for your largest customer will also be applicable to your general customer base.

Consider the segment of your largest customer. How can you improve your marketing strategy to better target that segment?

Ask yourself: Are your salespeople capable of consistently selling to other large customers? If they’re unlikely to close similar deals in the future, you could be setting yourself up for future problems.

Keep in mind that even if you don’t have a concentration problem right now, one can develop over time. Recall above: your larger customers can sap resources from your smaller ones, meaning it’s easy to expand those customers while neglecting the others. Sometimes, this means that large accounts expand exponentially while smaller ones stagnate. This will lead to a concentration problem over time.

Once again, mitigate risk by pushing account expansion and emphasizing stellar service for all customers (especially the smaller ones).

📝 A brief overview of customer concentration

Customer concentration risk is a primary threat to SaaS businesses. However, it’s easy to avoid with some foresight and planning. Remember, don’t eschew the importance of smaller deals, and take steps to protect yourself against the loss of your larger ones.