Key Client Risk
Key clients are great, right? But are they risky? And how might they be affecting your business’ value?
Let’s address the importance of achieving a well-diversified client base to increase your business’ value, and how the reliance on key clients can impact the risk perceived by investors in your business, which can in turn affect your business’ value.
When small businesses have a limited number of clients, or a small number of clients that represent a significant portion of their sales, valuers and investors define the company as having “key client risk” or “client concentration risk”.
Key client risk is perceived because there’s a potential for the company to lose a big chunk of its expected sales if the client leaves for any reason. This risk increases the discount rate of your business, which represents the investors’ required rate of return relative to the risk perceived in the business.
You may have heard of multiples to value a business—where a business is valued by taking their earnings (profits) and multiplying by four to get the business’ value For example, $1 million in earnings, times a multiple of 4, makes the business value $4 million. The multiple of 4 represents a discount rate of 25% (1 divided by 4).
Now, if investors perceive a higher risk in your business due to the high reliance on key clients (let’s say 70% of your sales stem from one client), the discount rate would increase. For example, say the discount rate of your business is set at 25% without key client risk, and let’s assume that with key client risk it increases to 30% (a multiple of 3.33, or 1 divided by 30%), your business would now be valued at $3.33 million.
A valuation of $3.33 million represents a decrease of approximately 17% when compared to the initial valuation of $4 million, a huge loss to your wallet if you are planning to sell.
The example above is a very simplistic way to value a business. But our aim is to point out the impact that key client risk can have, and the importance of investing the time and resources to diversify your client pool if you are planning an exit or looking to apply for a loan, or simply lowering your business’ risk as part of good business practices and sustainability.
For a small business, losing a key client could mean resulting in a business failure. For the reasons explained in this article, investors and valuers see significant risk when there is client concentration, and they price your company accordingly.