Many outstanding, profitable businesses have an issue with customer concentration. This doesn’t only affect small businesses – even large public companies struggle to give investors comfort if they have an especially large customer or supplier. In a way, customer concentration is one of the greatest indications that a company has created real, lasting value. Why else would a customer choose to spend millions of dollars with them year after year?
Yet customer concentration does present a huge risk to a buyer of a business, whether professional or individual. Buyers will typically a finance a business purchase with a loan based on the company’s cash flows. If the biggest customer disappears the day after the sale closes, the buyer may be stuck with payments they can no longer afford and a business that is worth far less than the one they bought. A loss of a large customer that would have been painful but manageable before the acquisition becomes fatal after it.
Further, there is an inherent problem of information asymmetry. The seller knows far more about the prospects of continued business from its largest customer than the buyer ever will, no matter how many good questions they ask. The perfect time to sell is right before orders dry up from your biggest customer. Even though a seller may be honest and have no reason to deceive the buyer, they will obviously try to sell right after orders have been especially strong. That risk is often sends otherwise suitable buyers running away.
The solution to this, like so many problems, can only come from shared risk and partnership. The buyer and the seller need to openly acknowledge the risks of the customer concentration and work together to address it. A model that can work well is essentially splitting the P&L into two parts: the “business” of serving the large customer, and the “business” of serving everyone else. Costs need to be assigned to both to ensure that the business is sustainable if its largest customer were to disappear.
Assuming the business is healthy, though smaller, without its largest customer, the size of the traditional small business loan should be based on that remaining business. The profits from the largest customer should be dedicated to a larger than usual seller financed note and/or earn-out. If business from the largest customer remains stable or grows, the seller should benefit from this. If the business from the largest customer shrinks or disappears, the seller needs to bear the risk of that. Part or all of their seller note needs to be dependent on the largest customer purchasing as projected.
Nothing is without risk, and this approach certainly does not eliminate it. The seller must accept the risk that the new buyer may “screw up” the delivery to the large customer. The buyer must accept that their returns will be more variable than from a fully diversified business. But compared with the alternative of a failure to sell or a sale at a distressed price, this approach is far more likely to meet the financial goals of the seller and reward the buyer appropriately for their risk.