Are you in the 30% Danger Zone?
Are you in the 30% Danger Zone?
May 21, 2018
Closing a major customer can be one of the best feelings for entrepreneurs. Getting a major contract or order can completely change the trajectory of a business by providing much-needed cash flow and validating months or years of work.
However, closing a big sale like this can be a double-edged sword.
The Tyranny of the Big Sale
When a company makes a sale to a big customer, a number of things happen inside the company. Usually, the company needs to increase some routine expenses in order to meet the demands of the sale. This usually means hiring staff or building up some inventory above what is usually required.
This increase can strain internal processes and systems if they were not built to scale up with the increased needs. The increased staffing usually requires more specialists, meaning that delegation becomes more important. This can cripple a micromanaging owner that can't let go of the reins.
Many companies quickly realize that what worked for their production simply can't bear the weight of doubling in size so quickly. This often results in delays and decreased quality in the final product, which often compromises the Big Sale or, in worst-case scenarios, strains the company to the point of closing.
The 30% Danger Zone
Companies that survive this quick success aren't out of the woods just yet. In the consulting and M&A industries, companies that generate more than 30% of their gross revenue from a single customer are considered to be in the "Danger Zone." These companies are valued at significantly lower valuations and subject to a much higher level of scrutiny than companies that spread revenues over a more diverse clientele.
The main reason for this is profitability. Most companies run net profit margins of less than 30%. Therefore, if a customer that consists of 30% of gross revenues decides that they are terminating their business, a decently profitable company becomes an unprofitable one overnight. Now, in order to stay profitable, the company has no choice but to lay people off or find other ways of cutting expenses.
The second reason the Danger Zone is so precarious is because of Bad Customers. Most customers aren't Bad Customers. At worst, they're usually neither good nor bad, sitting somewhere in the middle. However, a fairly large minority of customers will be what anyone would consider to be a Bad Customer. These are your classic customers that demand too much, communicate too little, and rarely pay in full or on time. Many of these Bad Customers can be malicious and cut-throat. If one of these Bad Customers is a 30%+ customer, they can take advantage of the situation.
I have seen companies intentionally cancel orders, refuse orders on arbitrary grounds, and withhold payment for arbitrary reasons. There's an entire class of customers that are notorious in the collections industry as being the types that only make a payment after lawyers get involved. These Bad Customers can take advantage of a company.
Avoiding the Danger Zone
Avoiding the Danger Zone is, unfortunately, not always possible. A lawyer can help, because we mitigate the risks involved with dealing with these types of customers. There are a number of things that we can do to minimize your exposure to a Bad Customer, such as negotiating
- Sales parameters, including specifications for delivery, payment, and quality, so that there are less opportunities to "wiggle out" of obligations,
- Minimum purchase requirements, that ensure that at least some base level of purchasing will be conducted by the customer,
- Fee-shifting provisions, which require the losing party to pay for attorney's fees and other costs of collections,
- Term lengths, which commit a customer and company to work for an extended period of time, or at least giving the company an opportunity to respond to significant changes in the relationship,
- Liability limits and shifting, so that a company does not become responsible for actions taken by the customer,
and many other provisions that are designed to increase transparency and mitigate the risks of navigating the Danger Zone.
Arguably the best way to navigate the Danger Zone is to grow through it. A successful entrepreneur told me that the best day of his life was when he signed that 30%+ Big Sale customer. He told me that the worst day of his life was the next day, because he then recognized the dangerous position it put his company in. Instead, he used that as motivation to grow the company to such a level that one customer couldn't bankrupt their operations. So he redoubled his sales efforts and was actually able to use the Big Sale as leverage to sign two other customers in a short period of time.
Bottom Line
Having a single customer that generates more than 30% of a company's gross revenues can be a significant liability. This is largely because the loss of that customer can instantaneously make a company unprofitable, and many customers use this as leverage to get what they want. However, well-drafted contracts can help to mitigate this risk.