Navigating Business Acquisitions with High Customer Concentration

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In business acquisitions, high customer concentration presents a unique set of challenges and risks. A recent discussion on the Searchfunder forum highlighted a case where an entrepreneur considered acquiring a business with substantial revenue concentration in just two clients. This situation provides an illustrative example of how potential buyers can approach similar scenarios, emphasizing creative financing solutions and risk mitigation strategies.

 

The Scenario

The business under consideration boasted impressive figures: approximately $1.4 million in revenue and $550,000 in EBITDA, translating to an enviable 40% profit margin. However, the business’s reliance on just two customers, each capable of terminating their contracts with only 30 days’ notice, posed a significant risk. The seller was open to a sale but did not offer seller financing, and the business was valued at less than 5 times EBITDA.

 

Community Insights and Strategies

The forum discussion brought forth a wealth of opinions and strategies from seasoned professionals in the M&A field, emphasizing various approaches to manage the inherent risks.

 

Seller Financing and Earn-Outs

Many contributors suggested leveraging seller financing to offset the high risk of customer concentration. This could involve structuring the deal so the seller retains some risk, potentially through an earn-out or a forgivable seller note. Earn-outs would be particularly strategic, with payments tied to the business maintaining its current revenue levels or specific customers.

As Dustin Owen, Managing Director at Longview Growth Partners, recommended, “I would be weighting consideration heavily to earn-out or VTB tied to customer retention.

 

Understanding the Business and Its Market

Due diligence was a recurring theme, with suggestions to deeply understand why the business has only two customers and the barriers to expanding the customer base. Engaging directly with the existing customers to assess their satisfaction and likelihood of continuing the service would provide critical insights into the business’s stability.

Leopoldo Lima from Questum Startups pointed out, “The average ticket of $700k and EBITDA margin of 40% seems interesting… how can you replicate this with multiple customers?

 

Leveraging the Business’s Niche Position

The business’s role as a leader in a niche B2B services industry should not be overlooked. Potential buyers were advised to explore how the business achieved its current position and whether its products or services could be diversified to attract more customers, thus diluting the risk associated with current customer concentration.

 

Negotiation Leverage

Given the risks, several participants noted the potential for negotiation leverage. The buyer could argue for a lower price or more favorable terms considering the significant risk posed by the customer concentration. This might include suggesting a lower multiple or insisting on protective clauses in the sale agreement.

Wes Shelton of SM2 Advisors highlighted, “Seller expectations aren’t in line with the risk profile of this business… I would put as much of the risk as possible on the seller (earnout) otherwise this just seems like a sucker bet to me.

 

Exploring Non-Traditional Financing

With traditional bank financing likely challenging to secure due to the high risks, suggestions included looking into alternative lenders who might be more flexible with their terms or more willing to engage in high-risk transactions, possibly with higher interest rates or more stringent conditions.

Brad Hettich from Commercial Lending X remarked, “It is going to be very hard to finance with conventional debt… I would recommend pushing seller financing or an earn-out.

 

 

Exit Strategies and Contingencies

Finally, understanding and planning for potential exit strategies if the business’s key customers were lost post-acquisition was deemed crucial. This involves setting up contingency plans and having clear steps to either pivot the business model or minimize financial losses.

Philip Dillon’s comment encapsulates this approach: “At 3-4x, might make sense with heavy earnout (preferred over forgivable seller note). What is reason for sale? How involved is owner in business? How many FTEs? How critical is business to customers? Can business acquire additional customers?

 

Conclusion

The discussion underscores the importance of creativity, thorough due diligence, and strategic financial structuring when dealing with businesses exhibiting high customer concentration. Such acquisitions are fraught with risk but can be navigated successfully with careful planning and innovative thinking. For potential acquirers in the small business space, these insights are invaluable in shaping how they approach, negotiate, and ultimately decide on high-stakes business purchases.

This collective wisdom from experienced practitioners not only aids in decision-making but also enriches the knowledge base of anyone looking to venture into similar high-risk acquisitions, providing a roadmap for mitigating financial exposure while capitalizing on potential opportunities.

FAQ

Frequently Asked Questions

Acquiring a business with high customer concentration can lead to significant risks if one or more key customers discontinue their services. This can result in drastic revenue drops and affect the overall sustainability of the business.

? Seller financing is recommended because it aligns the interests of the seller with the buyer’s success. It can act as a buffer against the risks of customer loss, as the seller retains some of the financial risk post-sale.

An earn-out is a financing arrangement where the payment of the purchase price is contingent on the business achieving certain financial goals post-acquisition. This approach mitigates risks by ensuring that the seller remains indirectly invested in the business’s continuity and success.

Detailed due diligence helps identify the reasons behind the business’s limited customer base and evaluates the sustainability and satisfaction levels of these customers. It also assesses the potential for customer diversification and overall market expansion.

Alternative financing options may include private equity, venture debt, or other non-traditional lenders that specialize in higher-risk investments. These sources often provide more flexible terms tailored to unique situations like high customer concentration.

Buyers can use the high-risk nature of the deal as leverage to negotiate lower purchase prices, better terms, or protective clauses in the sale agreement, such as extended earn-outs or contingencies based on customer retention.

Contingency plans may include strategies for rapid customer diversification, operational adjustments to reduce dependency on key customers, or contractual agreements with existing customers to secure longer-term commitments.

Understanding the seller’s motive is crucial as it may reveal underlying issues not immediately apparent during initial evaluations. It can also provide insights into the business’s market position and the seller’s confidence in its future prospects, influencing the negotiation and risk assessment process.

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Picture of Written by Roman Beylin

Written by Roman Beylin

Roman Beylin is the founder of DueDilio, a leading online marketplace to assemble an M&A deal team. Our large and growing network of highly vetted independent professionals and boutique firms specialize in M&A advisory, due diligence, and post-acquisition value creation.

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