When concentration is a big problem for a small business
I have a pizza dough story.
Once upon a time, I was the banker for the owner of a small pizza joint who had just landed a contract to supply pizza dough for several stores in a national retail chain. This small business owner did such a good job that he soon found himself supplying the retailer’s entire west coast network.
Great news, right?
Because he was expanding so rapidly, he needed help financing this growth, so the owner came to me for a line of credit. Unfortunately, I had to decline his request.
Want to guess why?A devastating loss
Although his sales had skyrocketed, 85% of his sales were now with just one customer! I did my best to explain the dangers of having the majority of his business tied to one customer, saying, “What would happen if you have a disagreement with the retailer and they stop buying your product?” Needless to say, the business owner was upset and said he would find another lender to help him fund his growth.
Sure enough, two months later, he had a quality control issue and the retailer suspended his account. The loss was devastating. With the other lender’s funds in hand, he had bought new equipment and hired staff, ramping up pizza dough production to meet the retailer’s demand. Suddenly, he had to scramble to manage the 85% drop in sales. He struggled — cutting costs and laying off people — while trying to fix the quality control issue and salvage his relationship with the retailer.Balance in the customer base
So did you guess the pizzeria owner’s problem was concentration?
If you did, congrats. Concentration can be a big problem for a small business. But at what point does concentration become a problem? Well, ask yourself how much revenue you can afford to lose. How much can you lose and still make payroll, cover the monthly lease or mortgage payment, handle utility bills, and pay your vendors and suppliers?
If losing 10% of your revenue means you can’t cover payroll, then concentrating 10% of your sales with one customer could be a problem — no matter how solid the relationship.
From a lender’s perspective, 20% of total sales to a single customer of the business is a red flag. Anything over that percentage will have your lender looking very carefully at your company. If 25% or more of your sales are concentrated with one customer, you may have a hard time getting financing. Think of the additional financial risk if you were to lose a quarter of your business’s sales.A silver lining
There is a silver lining to this pizza dough story. When I checked in with my client to see how things were going, we had a constructive conversation about what he could do to mitigate his risks. While I could not help him with quality control, we did discuss his concentration problem and reset his expectations for reasonable growth and production. Finally, after several months, he was able to win back the retailer’s trust and have a realistic conversation about how much of their demand he could meet.
He reduced the relationship to 35% of his sales and worked to bring that percentage down even lower — to less than 20%. Over time he was able to grow his business with them, but he did it sensibly without exceeding his new 20% concentration rule. He had learned a good lesson.
The story points to the value of staying diversified — ideally you will have multiple customers and types of customers from diverse sectors, multiple geographies, and multiple products and services. In short, make sure all of your eggs are not in one basket.