How to mitigate the risk of high customer concentration before buying a business
By William Fry
Feb 23, 2024
In Buying a Business
Over the past month, we've been involved in a few deals that had larger levels of customer concentration. Customer concentration occurs when a minority of a company's customers account for an outsized percentage of its revenue.
The risk for buyers, lenders and investors is that one or two customers leave and all of the sudden the business is worth a fraction of what it was pre-closing. This would lead to defaulting on the SBA loan and a bust for investors.
While customer concentration itself is quite common in some industries (e.g., government contracting, logistics, etc), it’s important to have a deal structure that will allow the company to perform even if one or two customers decide to churn.
Generally speaking, a good deal structure should have the seller to bear some of the risk in the case of a customer churning.
Approaches to mitigating customer concentration:
Lower the price: The most brute force approach to customer concentration is to lower the purchase price. If using a multiple on earnings, you could exclude the earnings from the top 1-2 customers when valuing the business or value those earnings at a lesser multiple. That being said, this approach is the silver bullet, and for good reason. The owner has won valuable customers and wants to be compensated for them.
Structured seller note: The more common approach is to keep the price relatively the same and adjust the sources of funds. Most SBA lenders will want to cap their loan amount so that the debt service on the loan can be withstood even if the business loses a key customer or two. Practically, this often means a 50-70% LTV instead of 80-90%. To come up with the rest of funds, one option is to have a forgivable seller note. This note would be forgiven in the event of the business declining, allowing the business to continue making SBA payments without being driven into default by a seller note. The other option is to put a note on standby.
Increase equity: If the seller is not interested in a forgivable or standby note, the third approach is to increase the amount of equity going into the deal. This can come from rolling equity from the seller into the NewCo, increasing the amount of cash you and investors are injecting into the deal, or both.
As you can see above, a relatively uncommon approach is through customer contracts alone. Typically, the market won’t bear a long (10yr) contract term. And, having signed contracts for a few years alone won’t make a big difference, as the bulk of the SBA loan principal is still outstanding even in year 3 and 5.
One approach that isn't mentioned above is structuring an earn-out for the selling owners. While this is a good approach to hedge against customer concentration, it is typically not allowed for SBA-backed deals where we spend a majority of our time.
Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.
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