Customer Concentration - how to structure a deal

March 14, 2022

by a searcher in Highlands Ranch, CO, USA

Hi searchers - would love some ideas on how you would go about structuring a deal to address customer concentration risk.

Working on an LOI for a B2B service provider that has some significant concentration--they have a 25% client, 15% client, and 10% client, all longstanding clients of the company. They are a small company, enterprise value of ~600k. So this is a pretty small deal, but in an interesting and niche space with a good reputation. They are very resistant to the idea of giving me access to the clients post LOI and due to their small size don't feel that strategies like engaging a 3rd party survey type firm to talk to their clients will be inconspicuous.

How would you go about due diligence in this situation? And/or how can I structure the deal in consideration of the concentration risk.

I do plan to ask for a 20% non-recourse subordinated seller note. I'll use some SBA funds so earnout is not an option. I don't think they'd agree to a forgivable seller note based on retention of those clients, my understanding is that's pretty tough to get a seller to agree to in this market and they aren't desperate to sell.

Based on our relationship so far, I don't really think they are deliberately hiding anything about these clients or misleading or I'd walk away regardless, but they are protective of the clients and privacy of the deal. Obviously, you never know though.

Reply by an intermediary
from Arizona State University in Long Beach, CA, USA

A forgivable Seller Note would be ideal. If they are vehemently opposed to it, you could propose an Escrow Holdback for a short period of time (maybe 12 months).It should make them feel better that the money is sitting in Escrow, and the their risk is limited in terms of timeframe. 12 months gives you enough time to build a relationship with the customer, and at least mitigate part of the risk. For 25% customer concentration, I think that's reasonable.If it were much higher concentration, you'd need more risk mitigation.If you are competing against larger industry buyers, keep in mind that the 25% concentration may not scare them much.

As for customer due diligence...you can propose the Seller call the customer on the speakerphone with you in the room, and let the Seller ask the customer some questions that you two agree on in advance.General goodwill type call asking about their satisfaction with service, estimate of upcoming work (for planning purposes), etc. will give you reasonable assurance that they are not a jeopardy customer.You could just listen in and not talk to the customer at all, if that makes the Seller more comfortable.

Reply by a professional
from University of Minnesota in Minneapolis, MN, USA

It's a tough ask, but see if you can talk to the major customers as part of your due diligence. Invite Seller to be a part of the conversation.

Also, in theory, the assignability of the contracts currently in place might give you some security in carrying on the relationship post-closing, but if a customer walks in spite of the language in their contract, it puts you in a really tough spot (i.e. litigation is not likely to be a viable solution).

Another option, as you stated, was to hold cash and get creative with the structure of the Seller carry - are you paying rent or consulting fees to Seller's post-close? Can we build incentives in there (while staying SBA compliant)? Or a forgivable note. Or if that fails, any Seller Note is better than paying everything at Closing.

Small deals can be great! Good luck!

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