How would you structure this deal with demonstrated customer concentration risk? - Searchfunder

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by a searcher from Boston College - Wallace E. Carroll School of Management
in Boston, MA, USA

2w ago

How would you structure this deal with demonstrated customer concentration risk?

Hey All, Thank you all @redacted‌ @redacted‌ and others for your feedback on my previous post regarding personal guaranteed risk on an asset-light SBA deal (redacted and was hoping to get additional feedback. All of the feedback was greatly appreciated. Would love your thoughts on noted customer concentration risk and your thoughts on what determines your ceiling on a deal like this? Deal snapshot, kept general: 12+ year old Wholesale/Import Business serving big box retail and distribution channels, roughly 50/50 split. Lean low staff, owner-operated business. Owner has been focused on operating with near-zero selling and now wants to retire. TTM revenue ~$1.2M, gross margin ~70%+ (double-edged sword, pronounced upside and downside potential) TTM SDE ~$530K Offer lands at an SDE multiple in the mid-2x, DSCR still comfortably above 2.5x I believe complexity could be the enemy of this deal, so I'm trying to construct the least complicated deal that protects on the known retail (and distribution) customer concentration risks. I've built an offer with Forgivable Seller's Note with a simple % revenue loss that protects against large single customer loss. and use it as a negotiating lever on terms or just be ready to grow and accept the risk? Since I arrived at SDE myself, would you state your SDE multiple in your LOI or too small of a deal to worry (again, added complexity). Or do the details qualify a walk away to you? In response to some of your curiosity regarding revenue decline, the last 6 years showed a clear COVID bump in this wholesaler's industry, so normalization was expected. Recent years saw a continued decline and, from my analysis, has stabilized over the last 24 months to level, near pre-COVID levels. Some customer concentration did rear its head on this business in 2024, with a major retailer reducing SKU count (retail placement decision affecting many suppliers) while at the same time, recognizing this business's long-standing 100% fill rate relationship, this big retailer extended an offer of shelf space and a single private labeled SKU to this business. This is the primary cause of the 20% revenue decline from '24 to TTM. Concentration still a concern but mediated now with the decline and potentially in the forgivable seller note. This deal has been a slow burn since the Seller has been insistent on waiting for the other party to put forward a serious, structured offer. I'm actually glad for the time. With no sell-side broker and the Seller only recently securing M&A professionals, I've been left to calculate Cash Flow Statements, SDE, and COGS from raw Quickbooks reports, a risk that is only truly dawning on me. Since this is a 20-year wholesale business and the Seller's been using cash-based accounting, true accrual COGS has been difficult to determine. I arrived at the 82% gross margin through multiple years of beginning and end of year inventory plus the mid-year purchases from the tax records. This turned out to be inaccurate..... I was able to get my hands on a real Excel mess of TTM revenue by SKU # (sometimes over 10 SKUs related to the same item #) to do a bottom-up COGS calculation. ClaudeAI and I are best buddies by now and I was able to parse out by cross referencing against cost/item and freight that the true accrual COGS is higher than the tax documents revealed. The Seller's book values aren't lined up with the reality in the TTM. Gross margins are still strong at ~70+%, SDE ~530K, but I almost put in an LOI that was too high on this one. I don't believe this seller to be deceptive, they just knew their margins were great (between 70 and over 80 depending on item and channel) but never a major concern and operated on cash accounting to maximize tax reduction. For any buyer, true COGS is a critical piece of information and has brought my offer back to reality. I learned a very valuable (and thankfully free) lesson here. When dealing with unsophisticated Sellers (and brokers for that matter), you really need to get into the weeds on proving out the numbers, so you don't find yourself deep in expensive due diligence and find issues like this. @redacted‌ @redacted‌ really appreciated your inputs here and, on SDE, it surely has declined with revenue. With my extensive analysis of the data and conversations with the Seller, I fully understand the decline and stabilization. Thanks @redacted‌ @redacted‌ I also understand all the growth levers that are currently not being pulled and have priced the offer to allow survivability room in up to a 20%+ decline. @redacted‌ It seems my skillsets of sales, distributor sales channel building, major new account capture/account management, and logistics are a real fit for this one. Plus, I've always been drawn to the industry it operates in. My adjusted offer lands at an SDE multiple in the mid-2x, DSCR still comfortably above 2.5x. Forgivable seller note component has two forgiveness tiers (but may simplify to one) with the first sized to recognize a single customer loss within the first 2 years. The structure allows for growth in one customer can offset any decline of another, a fair structure I feel. Thanks @redacted‌ @redacted‌ The consignment agreement will have to be buttoned up by my attorney for protection. In this particular case, the Seller has accumulated an overstock of inventory, almost 1/2 of which is slower moving or dormant (some currently being liquidated). A clear consignment agreement allowing for agreed upon liquidation of slow items and dollar-for-dollar extraction of value is in both of our interests. Speed and conviction to close on a bankable deal (with the Seller's bank) with well thought out plans for a proper handoff and the Seller's oversized inventory are my advantages here. A competing buyer is still flailing a bit with offers that put way too much note risk on the Seller and a timeline that would likely lag beyond Seller's ideal transition. The DSCR on their offer must be barely above 1.25x, so I suspect they've certainly not done the deep analysis this deal requires. I'm not chasing their numbers. I may end up losing this one to a pie in the sky seller financed offer from a party who hasn't done the work, but we'll see. I feel like the analysis on this deal has been an advanced education. I also see this as a "buy small and build" situation where me and a very small crew will be growing this business and adding headcount with revenue. If I can get this LOI signed, that is!

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reply by a searcher 2w ago
from Northwestern University in Dallas, TX, USA

Appreciate the tag, Luke. @redacted‌'s response is bang on and in itself a masterclass.

reply by an intermediary 1w ago
from University of Virginia in Metuchen, NJ 08840, USA

Getting the LOI signed will depend as much on the emotional levers you can pull as on the rest of the deal-structuring advice here. A mid-2x SDE multiple with a DSCR comfortably over 2.5x gives you substantial breathing room. However, wholesale/import businesses with big-box retail and distribution concentration carry distinct landmines: shelf placement shifts, chargebacks, inventory obsolescence, and working capital drag. Here is how to structure this deal to protect your downside while keeping the transaction simple enough for an unsophisticated, non-represented seller to sign. 1. Structuring the Forgivable Seller Note (Keep It Simple) You are spot-on that complexity kills deals with direct-to-seller negotiations. Avoid complex tiered percentage calculations or multi-variable formulas. Sellers view complicated formulas as "tricks" to cut their purchase price later. Option A: The Simple Revenue-Threshold Clawback (Recommended) Instead of tying forgiveness to a specific named customer (which can lead to arguments over whether a revenue dip was a lost customer or market-wide demand), tie it to total top-line revenue retainage: Structure: Make the Seller Note 20% to 25% of the total purchase price, amortized over 3 to 5 years. The Trigger: Insert a simple annual clawback clause: "If total business revenue in Year 1 or Year 2 drops by more than 15% below the TTM baseline of $1.2M due to customer loss or SKU reduction, the principal balance of the Seller Note will be reduced dollar-for-dollar (or on a set ratio) by the amount of lost gross margin." Option B: Earnout / Contingent Payment Transition If the seller bristles at the word "forgivable," reframe it as a Retention Earnout Note. Sellers hate feeling like money is being "taken away" (forgiveness), but they understand earning a portion of the purchase price by ensuring key accounts transfer smoothly over a 12-to-24-month transition. 2. Dealing with the Inventory Mess & COGS Wholesale and import businesses live or die by inventory accounting. Cash-basis tax returns in a business with big-box retail inventory are notoriously misleading. Because you already discovered that true accrual COGS is higher than reported: Establish a Strict Working Capital / Net Working Capital (NWC) Peg Target Working Capital: Do not pay extra for inventory that is required to deliver the $530K SDE. The purchase price must include a normal level of clean, usable inventory required to support TTM revenue. Dead/Dormant Inventory: You mentioned nearly half the inventory is slow-moving or dormant. Exclude dead inventory from the core purchase price entirely. Consignment / Liquidated Note Split: Usable Inventory (A-grade, fast-moving): Included in the baseline purchase price. Aged/Dormant Inventory (>120–180 days old): Place on a Consignment Agreement. You sell it on their behalf as orders come in (or via liquidation channels), remitting 50–70% of net realized proceeds to the seller as it clears out. This keeps your SBA loan size lean and avoids paying dollar-for-dollar for inventory you might have to write off. 3. LOI Specifics: Stating the Multiple vs. Stating the Dollar Figure Rule of Thumb: In an LOI for a smaller deal ($1M–$3M EV), state the fixed purchase price and the fixed SDE benchmark, but avoid locking yourself into a rigid "multiple formula" in the legal text. Instead of writing "We offer 2.5x SDE," write: Purchase Price: $1,325,000 Basis: Based on an agreed-upon TTM Normalized SDE of $530,000. Purchase Price Adjustment: Should Quality of Earnings (QofE) or financial due diligence reveal that TTM SDE is lower than $530,000, the purchase price shall be adjusted downward proportionally to maintain the implied valuation. This gives you a clear mechanism to adjust the price if formal diligence uncovers more COGS surprises, without making the LOI look like a dense, intimidating institutional term sheet. 4. Key Protections to Include for Big Box / Wholesale Operations Given big box retail dynamics, make sure your LOI and definitive agreement include: Vendor/Supplier Continuity (Crucial for Importers): Your $530K SDE depends on supplier pricing and lead times. Make the deal contingent on transferring or re-establishing core overseas supplier relationships at current pricing terms. Chargeback / Return Liability Sweep: Big box retailers frequently hit wholesalers with delayed chargebacks, slotting fee deductions, or return allowances 60 to 90 days after the fact. Ensure the purchase agreement explicitly leaves all pre-closing chargebacks, vendor fines, and fill-rate penalties as liabilities of the Seller. Representations on SKU Status: Require a representation from the seller that no major retail customer has given formal or informal notice of discontinuing a primary SKU line within the last 6 months.

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