Issue Discovered in Due Diligence

November 10, 2022

by a searcher from Northwestern University - Kellogg School of Management in Redwood City, CA, USA

I am currently in LOI with a business. During due diligence research, I discovered a seller/customer family relationship. In short, the seller has a sibling who is a senior executive team member at one of their customers. This was not disclosed in the deal data room. I am seeking additional details (revenue through that customer by year, gross margins for those sales, etc). But a few questions for the community:

At what % of revenue does it become a red flag?

What else would you ask?

What would you do to mitigate risk? (Change offer to increase seller note with standby terms, equity position for more skin in the game, etc?)

Lastly, has anyone experienced this and have any good or bad experiences?

Thank you.

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Reply by a searcher
in Chicago, IL, USA

Might be a risk, might not. You're smart to look at the margins. The business or the sibling might be getting a sweetheart deal, but plenty of business is done on relationships. The main question is how does it impact performance post sale.

• Is the Note contingent on performance over time?
• What's the length of tenure on the sales contract?
• Did the business originate with the sibling?
• Is there a sales contract in place that overrides the relationship?

The Seller didn't disclose this for one of two reason (probably). First, the fact that they are siblings has nothing to do with the business so they didn't think it mattered (most likely). Second, they are hiding it and didn't want you to know.

I would ask the questions above and build in a performance clause as part of the PSA that values the business with and without the business. Consult your counsel as to how to properly navigate the language as it could kill rapport if you make unsubstantiated claims and move the goal post based on subjective observations.

That's why they call it due diligence – good luck!

Reply by a searcher
from University of Akron in Raleigh, NC, USA

I'd definitely dig into purchase orders/invoices and bank statements to validate what percentage that account represents in revenue. I'd probably also want some sort of picture of that account's contribution to bottom line profits as well if it's 20% of revenue or more. Top line revenue concentration may not always tell the full story of an account's significance.

I think customer concentration should be assessed on every deal. Certainly worth digging in further on this one to see if there are anymore concerns.

Seller note with forgivable/clawback terms related to maintaining current sales performance seems like the best mitigation risk. But I'd want to make sure there isn't a seller trust/integrity issue above all else.

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