How to mitigate customer concentration?

February 17, 2024

by a searcher from Columbia University - Columbia Business School in Washington, DC, USA

Hi all,

Looking at an otherwise great deal that has ~50% concentration in 1 customer. Need some advice on dealing with it. I'm most likely going with SBA debt so a true earnout isn't likely (but feel free to convince me otherwise).

Options I'm considering:

big forgivable seller note 20-30% (usually the max I've seen sellers entertain, but may still go bankrupt if lose big customer)
huge forgivable seller note 50-60% (sized for DSCR of 1x in event of losing the big customer)
if not bankable, attempt all seller financing

How else can I mitigate? Can I ask to approach the big customer as part of the closing contingencies?
Would seller rolling equity help?

Any creative ideas would be much appreciated.

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Reply by a professional
from University of Miami in New York, NY, USA

As part of the purchase agreement, one of the contingencies that the Buyer should rely on is an affirmative covenant where the Seller agrees to facilitate a full assignment of their existing contract, and perhaps given the concentration, have the Seller agree to a contract extension with that big egg in the basket.

Honestly though, if the cash flows of the business are concentrated in one contract, the customer has all of the leverage, and that should represent a sizable discount to valuation (reflecting the risk of loss associated with the sole customer departing). A hedge to that could be some sort of insurance (business interruption) associated with that contract.

In the interim, you have to develop a solid plan to diversify the client base. Alternatively, once you acquire, maybe develop a relationship with the principals of that customer, and after that relationship is solid, offer to sell them the company you just acquired to "in house" the services of the acquired company into the customer.

On reflection, the most suitable buyer for that business would have been the outsized customer itself. Let me know if I can assist in any way. redacted or###-###-#### .

Reply by a searcher
from Indian School of Business in Raleigh, NC, USA

I think you are asking two questions 1) How to I convince banks to accept my deal? 2) What do I do about the concentration operationally to mitigate it? Both are big questions. For 1) you should first speak to your lender and other lending experts and get their views on various possible methods. For example, you might be able to rightly represent the big customer as more than one customer if different departments/geographies are buying from you which have different authority structures and needs (I am personally aware of a case where this worked well). Then there is the financial engineering with the seller note that some have alluded to. For 2) you are looking at strategies to make yourself stickier to the customer, which varies a lot by industry. My rule of thumb has been that I can get comfortable with customer concentration to the extent that I am confident of being able to add customers / grow business, because I can dilute the concentration to that extent.

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