When Ten Customers Are Really Just One

In my experience, concentration risk (CR) is easy to spot and easy to misinterpret. What many know as CR is a situation where a significant portion of annual sales comes from a single buyer. The primary concern here is that if that buyer walks, you have a huge setback. The secondary concern is that said buyer could squeeze you on margins or be a genuine pain to work with, and you will have no choice but to abide. Let's look at the empirical method of calculating this. The Herfindahl-Hirschman Index (HHI) came about from two separate research efforts – one on how to measure concentration in the steel industry and the other on how to measure the trade power of nations. Today, HHI is the gold standard used by the Department of Justice for assessing potential monopolies in their merger guidelines. Here's the simplified calculation: square the market share (assume the percentage is a whole number) of each firm in the industry and sum the results. The larger the result, the higher the concentration in the industry, meaning fewer firms commanding larger market shares. Here's an example: Electrical contractors in Dallas County Company | Market Share | Market Share Squared Infinity Electric 18% 324 Meridian Services 15% 225 PowerGrid Solutions 12% 144 Voltage Contractors 10% 100 Summit Electrical 8% 64 Apex Power 7% 49 Circuit Systems 6% 36 Total HHI 942 (real company names, made up market share) An HHI below 1,500 indicates a competitive market. Between 1,500 and 2,500 suggests moderate concentration. Above 2,500 signals high concentration. In this example, Dallas County's electrical contractor market has an HHI of 942, indicating healthy competition with no single firm holding dominant power. The same methodology can be applied when looking at a company to understand revenue concentration. You square the annual revenue share of the top 50 clients by revenue. A good QoE should have this analysis and move beyond generic statements such as "60% of revenue comes from 3 clients." HHI allows you to see how much riskier (in terms of concentration) a company is compared to its previous year or to another company. Let's look at the "60% from 3 clients" scenario under three different distributions: Company A – 20%, 20%, 20%. Loss of their biggest client is a 20% hit on revenue. HHI is 1,200. Company B – 23%, 20%, 17%. Loss of their biggest client is a 23% hit on revenue. HHI is 1,218. Company C – 48%, 7%, 5%. Loss of their biggest client is a 48% hit on revenue. HHI is 2,378. Company C is twice as risky as Company A, despite all three companies deriving 60% of revenue from three clients. Also, if the HHI calculation included all clients, you get one number that you can compare year-over-year and against other companies in the same industry. Now that we understand the arithmetic, let's take a step back and ask ourselves what we are really indexing for when we say "concentration risk." Ultimately, we want to avoid being at the mercy of anyone, not just customers, but suppliers as well. Customer Concentration and Its Many Faces Customer concentration is the obvious CR which we explained earlier. Here are some other subsets of customer concentration that I like to consider: Industry concentration: Company A and Company B are electrical contractors. Both have 60% of their revenue from 3 clients (20% each). For Company A, all three clients are data centers. For Company B, one client is a food packaging manufacturer, another is a data center, and the third is a school. Despite the same HHI, Company A is riskier, and a prospective buyer should be aware of such nuance and plan accordingly. This becomes even more difficult to spot when HHI is low. Say you have 50 customers, each accounting for 2% of revenue. On the surface there is no concentration risk. Buyer smiles. Everyone is happy. But if all 50 customers are data centers, the buyer needs to understand the inherent risk here. A major decline in AI demand, more efficient processors, or government policy, basically any adversarial impact to that industry, could cascade into loss of multiple clients simultaneously. I usually explain it to buyers this way: if all your customers respond the same way to an external shock, then you effectively have just one customer. This is not always a walk-away red flag. In many cases, it could be the secret to a business's success. Deep industry expertise, specialized equipment, established reputation in a niche. But it is useful information for the buyer to be aware of and plan accordingly. You need to understand the industry's health, its cyclicality, and stress test in your projections whether your business model can survive a downturn in that specific sector. Geographic concentration: Similar to industry concentration, but location dependent. If you serve 30 restaurants, but all 30 are within a three-mile radius in downtown Dallas, you have geographic concentration. Local economic shock hits such as a major employer leaving town, foot traffic declines, and restaurant closures follow. Geographic concentration can also create operational blind spots. The business might have systems and relationships that only work in that specific market. The local permitting process, the regional supply chain, the labor pool, all optimized for one geography. When you try to expand or when that market contracts, you discover the business wasn't as transferable as you thought. Ownership concentration: This is less common, but I have seen it enough times for it to be worth mentioning. If you have 50 customers, each accounting for 2% of revenue, you might assume perfect diversification. However, if five of those customers are owned and controlled by the same private equity firm, you effectively have 46 customers, not 50. And the 46th customer accounts for 10% of revenue. This happened on a deal I reviewed last year. The target company provided maintenance services to quick-service restaurants. The CIM showed 80+ locations across six brands – Subway, Taco Bell, Wendy's, Pizza Hut, KFC, and a regional burger chain. Beautiful diversification story. Due diligence revealed that 30 of those locations were owned by the same franchisee group. The group had been consolidating vendors and had recently put all maintenance services out for bid. The seller's company won the last round, but the contract was up for renewal in fourteen months. Suddenly, "80+ diversified locations" became "50 locations plus one large franchisee who could walk with 38% of revenue." Again, good diligence should catch this. On its own, it is not a red flag. In fact, having a large, sophisticated customer with multiple locations can be an asset. They provide volume, they pay on time, and they value reliable service. But insights like this equips the buyer with information to price it in, understand the real customer you are serving, and know what happens if that relationship changes. End-customer concentration hidden behind distributors (the sneakiest): This is where concentration risk gets truly deceptive. You look at the revenue breakdown and see 15 customers, each representing 4-8% of revenue. No single customer over 10%. The seller tells you they sell through independent distributors, which sounds like diversification. What the seller does not tell you, and what many buyers fail to investigate, is that those 15 distributors all serve the same three end customers. You are not selling to 15 independent decision-makers. You are selling to three end customers who happen to buy through different intermediaries. I saw this in an industrial components business. The company supplied specialty fasteners to distributors serving the wind energy sector. Revenue looked beautifully diversified: 12 distributors, none over 9% of sales. The buyer was comfortable. Six months after closing, one of the major wind turbine manufacturers changed its approved vendor list. Overnight, eight of those 12 distributors stopped ordering. They had no choice; their end customer dictated the components. Revenue dropped 60% in one quarter. The seller had not lied. The business really did sell to 12 distributors. But the seller also did not disclose that those distributors had no independent purchasing power. They were pass-throughs for decisions made three levels up the chain. When you see distribution-based sales, always ask: Who is the end customer? Who makes the purchasing decision? If the answer is vague or the seller deflects, that is your signal to dig deeper. Sales rep concentration (almost never disclosed): This is the concentration risk no one talks about because it does not show up in customer lists or revenue reports. But it is one of the most dangerous. You buy a business with 50 customers and diversified revenue. What you do not realize is that 70% of that revenue comes from relationships managed by one salesperson or the owner! That person does not just "handle accounts." They are the relationship. Customers call them directly. They negotiate terms. They troubleshoot problems. They know which customers pay late, which ones are growing, and which ones are about to churn. If that person leaves, you lose institutional knowledge and, potentially, the customers who were loyal to them, not to the company. This is more common than you can imagine, especially for small B2B industrial businesses. Here is how to spot it: During diligence, ask for revenue by sales rep, not just by customer. If one person controls a disproportionate share, that is your risk. You can also backdoor this with payroll statement and commission per sales rep. Then talk to that person directly, not in a group setting with the seller present. Ask them about their relationships, their plans, and what keeps them at the company. Listen to what they say not what you want to hear. As Ken Hersh will say, yellow lights don’t turn green. Their answers will tell you whether you are buying a business or renting a Rolodex. Why This Matters Concentration risk is not something you spot once and move on. It is something you index for continuously because it changes. A business that looks diversified today can become concentrated tomorrow, not due to customers leaving, but because the top three grew faster than the rest. Study the HHI analysis over multiple years not just the recent year. Understand that a company accounting for 20% revenue does not necessarily mean it will account for 20% next year. The point of understanding concentration is not to eliminate it. In many small businesses, some level of concentration is unavoidable. The point is to know where it is, price it correctly, and plan for what happens when it shifts. Because it will shift. The only question is whether you see it coming. Supplier concentration operates under different rules. Losing a customer hurts revenue. Losing a supplier can shut you down entirely. More on that later this month. www.prairie-crossing.com