Mitigating high customer concentration

October 14, 2023

by a searcher from Duke University - The Fuqua School of Business in Washington, DC, USA

I’m looking at a business where the top 3 customers account for 45% of the revenue. I would only move forward if the seller would agree to at least 50% seller financing that’s tied to performance of these customers for the next 5 years, where each year a portion of seller financing may or may not be forgivable depending on whether any of the top customers are still buying at similar levels. Any advice on how to approach the structure?

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Reply by a searcher
from Tufts University in Jersey City, NJ, USA

Whether you frame it as a hold back or as an earn out, it sounds like some manner of hedging is appropriate on your end to ensure that you're not left holding the bag if major customers disappear near-term after new management arrives. However, I doubt the seller will like the idea of tying a conditional mechanism to specific customers, as that creates potential scenarios where you are made whole and they aren't: i.e. one of those customers might fall off, but in the interim you've acquired new/offsetting business to maintain or exceed the originally underwritten performance. I'm also guessing they'll balk at any portion of purchase price being conditional as far out as 5 years. While those relationships are critical to revenue (at least currently), at a certain point a fair expectation is that there is a transfer of responsibility to new ownership to maintain those relationships. If you lost one of those key customers after you've been operating the company for 3 years, the seller is probably going to wonder why that's something that they should be penalized for. The big question is whether you're comfortable buying a company with that kind of concentration of risk, and whether you feel you have a deep enough understanding of why those 3 key customer relationships work and how to ensure they stay intact. At the very least, I'd make sure that my valuation multiple reflects the downside risk at hand, especially if there aren't clear upside paths that would allow you to drive down your purchase price (other large customers in the space that you might acquire, etc).

Reply by a professional
from University of Toronto in Toronto, ON, Canada

The best earn-out is the simplest and this one is the antithesis of simple! For an earn-out to be accepted, the seller must be comfortable that it can't be manipulated against them. However, your structure essentially penalizes the seller for customer conduct that is outside his control potentially many years in the future when management of the customer relationship properly belongs to you as the owner. That's unfair to the seller and will generate considerable resistance to accepting your LOI. You need to come to grips with the fundamental issue; namely, what is the probability of a significant disruption in 1 or more of these 3 core customer relationships based on historical company data and general industry intelligence? If you can't quantify that risk within a reasonable margin of error, then walk away from this and move on to the next opportunity where the market risk is more readily identifiable and understandable. [And read Bill Wagner's comments above, they're all on point.]

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