Getting Comfortable With High Customer Concentration

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by a searcher from University of Chicago
in Philadelphia, PA, USA

1yr ago

Getting Comfortable With High Customer Concentration

Hi all,

Some of the companies I've been looking at have been attractive with the exception of substantial concentration risk (i.e., one customer making upredacted% of revenue). Some of these have multi-year contracts which allow for partial payback under the contract that will be in place at close, others just have long-term (decades-long) relationships with the customers with high barriers to entry for competitors, and some have a combination.

I would be interested to hear how you get comfortable with these sorts of risks (if at all). I would also be interested to hear how this has impacted your valuation multiples and structure (i.e., more equity roll or seller financing to align interests / get the seller aligned to support contract extension / relationship management in case something goes wrong).

Thanks,
Ted

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reply by a searcher 1yr ago
from Harvard University in Toronto, ON, Canada

This is 1 metrics but not the only metrics. You need to know the industry, market, other metrics too well to weigh them correctly. It is not industry specific. To deal with customer concentration you will need an expert to work alongside you to structure the deal best, negotiate brutally, or you are out of business. If you are new beginner do not play this close call yet. Get sharp with 2-3 deals then face customer concentration head on

reply by a searcher 1yr ago
from University of Chicago in Philadelphia, PA, USA

Thanks, everyone – I appreciate all of your feedback. Replying jointly, the only things I would add here as I have been thinking about this:

I’m an independent sponsor, not a searcher, and I am not going the SBA route. With this binary risk, I would not be able to get comfortable with a PG. In this particular example, the company has multiple multi-year contracts. I have requested a breakdown of contracts by time remaining in the contract, with the hope that I can use this to calculate a downside case where the contracts all roll off and we get no new business. It’s hard to imagine this would be material enough to raise any debt financing unless there were other factors that could make the case, such as very high barriers to entry for competitors (still very unlikely to raise debt even if this was the case). As part of this, I will have to review termination provisions as well.

As others have noted, this probably looks like an equity raise coupled with seller financing and / or an earnout. Without getting too specific, this business is asset-light and has the potential to grow substantially if it can effectively secure new contracts, in which case, it seems well equipped to take on the new business with its current infrastructure. Subject to deeper due diligence proving out a strong base case and upside case, it seems like this could be a good fit for investors who are willing to take on the binary risk of the initial renewal in exchange for high upside.

As part of assessing the company’s relationship with the customer, I am also thinking about implementing non-compete provisions with the seller, since this business is asset-light and could theoretically be rebuilt by someone with the right relationships and knowledge.