Revenue concentration

June 18, 2021

by a searcher from INSEAD in Toronto, ON, Canada

Looking for approaches around structuring of LOI's for targets with significant customer concentration (~50% of revenues attributable to the largest customer but with a historical relationship with the seller).

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Reply by an intermediary
from Northwestern University in Orlando, Florida, USA

First, as you know, the valuation of the firm will be reduced due to customer concentration, but let's assume you have the correct valuation. A common approach is to include an "earnout" in the LOI, whereby a certain portion of the purchase price is tied to the revenue generated from the largest customer. For example, the seller will be paid 50% of revenue generated from the largest customer during months###-###-#### after closing, subject to a maximum amount (which helps for tax purposes). To ease the seller's concerns surrounding an earnout, keep the maximum amount they might receive in escrow. The seller can even earn a return on the amount in escrow, as it can earn interest or be invested in securities. Reduce the remainder of the purchase price by the NPV (from the seller's perspective) of the earnout. If the largest customer is retained, then you are happy to pay a higher price because you realize the customer is likely to remain past year 2. If the largest customer attrits, you are protected, assuming that the remaining business continues to be sustainable. If the remaining business is not sustainable, then the business as a whole is not a good one.

Reply by a searcher
from London School of Economics and Political Science, University of London in London, UK

We are currently looking at a deal with a high level of customer concentration (top 3 are 75% of revenue) and facing the same discussions. The problem seems to be, if you try and structure around it, your day 1 payment to the seller has to be pretty low (as % of total consideration) and the deferred element would be highly uncertain to the Seller so it almost makes more sense for them to keep the business, take the cash flow and get the concentration level down and then bring it back to market for sale. The other question I'm asking myself - does a seller note/earnout really solve the issue? Both instruments would have to be pegged to customer concentration in some way and why would the seller take on this risk when he/she will likely not be in control post-acquisition. There is a risk the buyer could mess up the relationship with the customer and the seller would then suffer. Maybe I'm overthinking it but overall it feels like meaningful customer concentration risk puts most deals in the too hard pile unless you have significant experience in the industry and can manage that customer relationship (i.e. you're a trade buyer).

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