Dealing with Customer Concentration when Selling your Business

23 Jul Dealing with Customer Concentration when Selling your Business

Shoot The Moon

Dealing with Customer Concentration when Selling your Business

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Mike Harvath and Ryan Barnett discuss the risks & benefits associated with high customer concentration in tech-enabled services and founder-led businesses during M&A transactions. They highlight the importance of structuring deals to mitigate these risks through earn-outs, gain shares, or collared note seller financing. The pair also discussed various methods for structuring deals when business owners are exiting their companies, including earn-outs, holdbacks, seller notes, and other financing options. Tune in now.

EPISODE TRANSCRIPT

Mike Harvath  00:07

Hello and welcome to this week’s Shoot the Moon podcast, broadcasting live and direct from Revenue Rocket, World Headquarters in Bloomington, Minnesota. Revenue Rocket is the world’s premier growth strategy and M&A advisor to IT services companies. With me today is my partner, Ryan Barnett. Ryan, welcome.

Ryan Barnett  00:27

Hey, Mike. Thank you so much for having having me on and thank you for hosting this podcast. For years we’ve been doing this, and it’s great to hear the feedback from customers. If you are listening to this podcast today and you have questions about mergers and acquisitions or growth strategy consulting for a tech enabled services business, please let us know we’re over at info@revenuerocket.com, we’re happy to address your question on a future podcast. The other thing we talked about on this podcast is what we’re seeing dealing with in our transactions. And one thing that is interesting we see a lot in IT services companies, I would say, more than less, is understanding customer concentration in an M&A transaction. And so the context here, I’d really like to think that if you’re a seller and you’re potentially looking to take your firm to market, what is it going to look like if you happen to have a more customer concentration than what we considered normal? So Mike, help me understand. Let’s start this. Kick us off. Why is customer concentration such a significant concern in M&A transaction and also just also get us going? What’s normal in the world of IT services and tech enabled services for customer concentration? How much should a buyer expect at some of these firms?

Mike Harvath  02:01

Yeah, great question. Ryan, so let’s first of all talk about what customer concentration is. Customer concentration is when you have revenue concentration with one or a limited number of customers that make up your overall revenue. And why this is a concern for buyers, or many buyers, is that they’re concerned that post transaction, they might lose one of those you might lose one of those customers, or maybe more than one, and if so, it’s going to interfere with their ability to get to their return rates, their internal rate of return, and ultimately, ROI on the investment in your business, should they acquire And this certainly can be a big deal now, different types of buyers and different types of IT services companies have different sort of norms when it comes to customer concentration. For example, when you have a MSP, oftentimes MSPs focus on kind of lower middle market, small, you know, small to medium sized firms, and they have lots of them with, you know, high recurring revenue. That’s part of why financial oriented buyers, private equity firms and other investors, are really interested in acquiring these businesses, and why the valuations for them have been, you know, buoyed by all of that interest. Because generally, they have a little customer concentration and high recurring revenue. From a contractual perspective, when you go to a digital transformation firm, or say, someone that does a lot of project work, or like a systems integrator, sometimes you can, you’re likely going to be working with particular in the case of digital transformation, larger companies, and it’s easy to get a bigger contract or longer term contract with those companies, and as a relatively small business, it can create a customer concentration issue just by you doing the right thing and working closely with those clients and delivering on their needs. You know, you might run into a very material, large client or two or three or four, and as a matter of fact, I’ve said for many years that digital transformation or custom software development type companies tend to, you know, have about, as a general rule, about 50% of revenue and five or less customers. And you know, most people looking at that would say it’s fairly concentrated. Now, if you’re a systems integrator of, you know, ERP software, for example, or CRM software, you still can have customer concentrations, but they tend to be a little bit less because those projects tend to be much more finite, and they tend to be implementation like engagements, and then they may move to maintenance and support, where in a custom development environment, you might have ever expanding needs around custom and implementation and integration and cloud transformation and a variety of larger. Larger type projects as you integrate. So hopefully that gives you a little bit of context to customer concentration. Ryan, and how the different types of firms in our orbit sort of see concentration.

Ryan Barnett  05:15

Yeah, I think it’s a great, great start, Mike, but we had seen, yeah, I would say it’s fairly common for us to see an MSP typically having one or two customers that have 5% ish concentration. I would say almost every company we dealt with is going to have some concentration. And we’ve seen that. We’ve certainly seen that much higher. We’ve seen companies it’s, it’s, you can see 40, 50, 60, 70% concentration. That sometimes concentration is also shown in repeat business. And I think that’s important to see. If you’ve had a customer since the day you founded the company, and still a customer that concentration risk might be limited a bit because it’s a long term customer. Now, I think what buyers are thinking about in this scenario is, what can we do to maintain that customer, and what kind of things can we do to make sure that it’s a smooth transition? So when you think about this Mike, are there some red flags that buyers would be looking for when we’re thinking about customer concentration?

Mike Harvath  06:28

Well, certainly, you know when you begin to think about again, you know you’re modeling your return rates as a buyer. You have to look at what happens. You still have to do some worst case scenario planning, right? And if there’s concentration risk in the business, and there is always, you know, some level of concentration risk, I guess, but depending on the perspective you have as a buyer, that may or may not be real relevant. So let me give you an example. So in a case of a MSP that may have 5% customer concentration, if you’re another strategic buyer, a large MSP and you have 1000s of clients, you have to remember that post transaction, that risk for that particular client goes down. So may not be as potentially catastrophic to the to the overall combined businesses, but you know, it may contribute to maybe not reaching the ROI and IRR thresholds on the deal post deal, but oftentimes that is based on how the deal is structured. Could be a problem for the former seller, depending on how they’re being paid out now, in the case of custom development or digital transformation, or cloud transformation shop, or even AI developer analysis, many of these companies have gotten a lot more into AI development. You know, we tend to see much higher concentration numbers, and that may or may not be an issue for a buyer. And the reason I say that is now, let’s say, you know, pick an extreme example, and you have 80% customer concentration on one customer, but that’s been a customer of that company for, you know, years, and it’s been ever expanding relationship, and it’s a good relationship, One that they’ve been able to keep competitors out and fortify the relationship with the client. And you’re a strategic buyer, or, let’s say you’re a sponsored or funded strategic and you have a very similar profile, right? You will understand how to manage and operate in a world of concentrated, large, in this case, likely Enterprise Client world. And you’ll be able to mitigate the risk of that concentration immediately when you integrate it into your book. And so, you know, we typically find in that world that tends to have a higher, higher tendency to be concentrated, and one where buyers tend to have a higher, you know, capacity or more tolerance for that. You know, deal with that in sort of a different way. Now, same thing would apply if your system is a greater app implementer kind of business. Now, at the same time, if you’re a financial buyer looking to do a transaction in which this is your platform, and you don’t fully understand the nuance of the micro market within the tech enabled services world, aka and MSP versus digital transformation versus system integrator, you may, you may have trouble thinking about this deal, because you have to get your head around that risk, and it depending on how you structure, the deal could become somewhat catastrophic if that customer was lost, for example. And so whether you’re on the buy side of a. Deal or the sell side of a deal. I think there’s just a lot of variables into whether concentration is a material issue in getting the deal done or not, how it impacts deal terms, you know, certainly something that we can talk more about. But each one of these micro markets manages and thinks about concentration, I think, in a very different way.

Ryan Barnett  10:21

Yeah, absolutely. And if I think about this before I jump into that question, and if I’m thinking as a buyer, what are my remedies for for this one, I guess one question I had to ask the seller is, what kind of contracts do you have in place? Mike, do customer contracts. How do those help a customer concentration issue?

Mike Harvath  10:51

Well, we could do a whole podcast and contracts, I think we have in the past, but they do help. You know, if they’re multi year or they’re exclusive, or they’re, you know, ones that have been renewed, or they’re evergreen type contracts, those are certainly can give a buyer more comfort that there is, you know, a plan, right plan for how you think about and manage that contract relationship, How you mitigate the risk of that client going away. You know, I often say, though, that unless you’re in the business to sue your clients if they want to break a contract, which we think is sort of bad policy, the contracts may have somewhat limited value. And I think if you’re a buyer, you certainly want to see that there is contracts in place. It’s not simply a handshake that there is some sort of, ideally, some sort of level of exclusivity, or at least protections should at, you know, the clients own decision. They can just cancel it. And you know, you know, you also, I think, much more importantly, have to look at the history of the quality of that revenue stream and the relationship with the client to the point with, point where, if you’re a buyer, and before close, you should be talking to that client, right? You should be having a conversation to say, how good is the relationship? What is your plan? We are contemplating a transaction with these guys, and would that in any way unearth your agreement with them? It may talk about change of control provisions in that contract. It might talk about their option to put out a particular work stream to bid or to look for a new vendor if there’s a transaction, all those things are important in, you know, the buyer evaluating the contract, and frankly, the buyer doing due diligence directly with that client to say, hey, we’re thinking of doing this. You know, what does that mean for you? I would say, overwhelmingly, even with change of control provisions, our experience has been that if the entity that’s providing the service is now bigger and more fortified with more capability, it actually can provide an opportunity for that company to do more with The new entity, with the new, you know, once that business is acquired versus less. And so, you know, you shouldn’t just look at downside protection. I think you have to be pragmatic also about, you know, how does one plus one equal three here with even a highly concentrated client?

Ryan Barnett  13:39

Yeah, you know, Mike, you talk about the relationship, that’s more important than the contract. I think you are. I think you’re right there. I would say, I guess the question I that begs to me is, oftentimes, when we see founder led businesses, that relationship is very high up in the organization. What advice can you give to sellers about the relationships that these firms have with the customers to help that to ease a transaction and transition to a seller.

Mike Harvath  14:12

Yeah, I think it’s super important and your relationship management and transferring a business to a new suitor or new owner, you know, as a seller, that’s one of the key relationship or one of the key responsibilities you have in integration, is to be able to build a bridge to a relationship, to that new suitor. Now you may be selling in and it makes it a little easier, because you’re going to be there longer, or maybe forever, for that matter, or at least as far as you can see today, and a relationship will still exist with you. But you know, being able to build a bigger team around you, you can translate, translate and create more points of light in the relationship with that corporation. Um. Is critically important. It’s likely that if you’re highly concentrated, you have a high concentration with a particular customer, that there is multiple levels of relationship with your business anyway, and you’re going to want to be able to expand that dramatically within the buyers business and create a relationship that is much stronger moving forward. Or, you know, the risk that everyone’s contemplating downside risk of that concentrated client going elsewhere might actually become a reality. So the biggest thing you can actually do to mitigate that risk and sort of keep it from occurring, or keeping a client from being a flight risk, is to certainly make sure that relationship is handled effectively, and that that relationship transfer and building that relationship with a new firm is one that gets done effectively.

Ryan Barnett  16:01

Yeah that’s great I think that’s great advice, Mike, to bring more people into the organization, to spread the wealth and contacts, to have things like a quarterly business review and to show the progress that you have within those target and large accounts can help show just how much value you’re at. And I think that gives a buyer, and it gives you as a seller, an opportunity to work with the buyer and say, This is how we cross sell and upsell. These are the opportunities that we have. And with you, Mrs. Buyer, we can greatly increase the speed of additional things that we can offer to this client, I think there’s a great opportunity, but people have to be on the same page. The relationships have to be well beyond a a founder and well into kind of more deep tentacles, as you mentioned. You know, I’m listening to all this Mike, and I’m hearing a lot of if a buyer was listening to this conversation, the first thing that might come to the mind is, if I have this large levels of customer concentration, they might be thinking of a purchase price adjustment and downward, frankly, downward, just because of the risk is, should buyers be thinking that, or are there other ways in which a transaction can be built in which the purchase price keeps to industry standard norms and acceptable terms?

Mike Harvath  17:33

Yeah, I think it’s natural for buyers to say there should be a material haircut for a firm that’s highly concentrated. From a value perspective, the problem is, typically, if you’re a buyer and you propose that the deal doesn’t get done, so it doesn’t really matter, and you can say that’s a justified sort of risk adjustment, and you decide that it’s important to make it. But our experience has been, if that comes particularly late in the negotiation, sort of post LOI  that it falls flat and can put the whole deal at risk. So there’s better ways to sort of manage it, I think, from a risk mitigation perspective, and that the business is worth what it’s worth, and regardless of the concentration, provided that concentrated client or clients don’t go anywhere, right? I mean, you’re assuming that if those clients don’t exit, then the business should hold its valuation, just as if it was not concentrated. And so the key there is to structure a deal where there’s a purchase price adjustment or risk mitigation strategy post transaction, should there be a flight? Or, of the any deals that there’s a flight, should there be a Exodus by a major client? And typically, those are done through what we would commonly call an earn out or gain share, or maybe some sort of collared note seller financing that says, hey, I’m going to do a hold back, and if this customer is still here within a year, then we’ll pay it out. Or, you know, whatever it might be, there’s a lot of variety structures that you can put in place to make sure that customer stays on side. And that’ll be a big incentive for a seller to make sure that, you know, they handle sort of the knowledge transfer and customer care philosophy and relationships to the new buyer effectively, so that they can get to that hold back, uh, however you might structure it, and it’s been an effective tragedy that we’ve used in the past for situations like this. And I think it’s one that creates a balance between the fight, risk of the customer and sort of value considerations on the in the case of the transaction, and it helps bridge, you know, getting the deal that.

Ryan Barnett  20:07

Mike can you explain just the caller and hold back just one more time? So I, if I, if I hear this right, and you have large customer concentration, a buyer is going to have, if you think about deal terms in general, there’s going to be typically cash at close, and that’s going to be a percentage, and there’s large customer concentration, it’s a natural given that there’s going to be less cash. There’s likely to be less cash at close, I guess. Is that a fair assumption? Or is that is that even wrong?

Mike Harvath  20:38

No, no, I think that’s absolutely a fair assumption. You’ve got to provide some warranty and fortify that warranty, that that customer is not going to go away, typically, for that buyer to get comfort that they should pay, you know, what may be perceived by the seller as fair value, as if there was no concentration risk, and that warranty comes in the in the effectively in a either earn out that says, hey, we’re going to achieve this sort of revenue and profit in the future, and if we do that, then we achieve this gain share or a portion of that revenue and Profit. And that portends that that customer is either specifically there, or that revenue and profits been replaced by someone. Should they go away? Probably the most common way that people would fortify the agreement, pursuant to concentration or like a holdback, might be, hey, we think there’s, you know, this particular deal, and this particular term warrants a several million dollar hold back, and we’re going to escrow that money pursuant to you having this customer active at its current level at some point in time, about a year from now, or two years from now, or whatever it might be, and then the escrow agent will release that money pursuant to that condition, the condition of, yep, customers still there, still doing the same amount of work or more. We release that holding, if you will. And you know, there’s also the provision of what we call a collared note, which is a seller note that says you’re essentially loaning that money to the buyer at interest rate, but the payment is on the condition that that customer is still at or above its same level of volume pursuant to the time The deal was done and, and that’s sort of another way you could do it, with a note, or what we’ll call seller financing,

Ryan Barnett  22:51

right? And a seller, I think, can, can expect a sliding scale, almost up or down. Sometimes it may not be a cliff. So if there, if there’s a variations in the business, that it could go down. I think buyers, it’s in a best interest of a buyer to have a cliff. If this customer does not produce this revenue, you don’t get any payment. I think there are cases in which that is appropriate, but sellers. That’s a lot to sell up for, or to sign up for for a seller. Mike, if you think about this, how, if you’re signing up for a hold back, is it likely that the you’ll be selling into the business, Or put differently, can you have a hold back and still sell out or retire or move on?

Mike Harvath  23:46

Oh, absolutely, yep. Yeah, it’s actually not terribly common that sellers might sell out or decide to retire or exit over a period of time and still have some sort of even an earn out provision. I’d say earn outs are less common in that situation than say, a seller note or hold back Partially, because you know, what’s contemplated in an earn out is that the seller is going to be there to continue to work every day and continue to earn that earn out right, continue to get to a point where they can create more value in the combined business that then exists at the time of the deal. And there’s other reasons you know earn out might work as particularly if there’s expecting a big spike in revenue, and you either have already signed up a contract or contemplating signing a contract, you got a strong pipeline. Oftentimes it’s in the seller’s interest to do an earn out, because they get a bigger they can enhance purchase price and get a bigger piece of value out of that deal. But yeah, there’s plenty of scenarios where people even agree to earn out when they’re not going to be there, if they’re confident in their team that they’re going to be able to. Deliver. In some cases, some of these business owners that are exiting, as far to they affectionately say, already work their way out of a job. They’re certainly working on the business and providing strategic direction and doing work, but the lion’s share the effort happens by the work of others. When they have a high degree of confidence in their team’s ability to deliver after they might exit, then, yeah. I mean, they could sign up for any combination of earn out, hold back seller note and be selling out.

Ryan Barnett  25:30

Yep, no, that makes, that makes a ton of sense, I guess, Mike, I think the only thing other area that I think we should touch on, can you help me understand kind of what types of representations and warranties, kind of reps and warrants a buyer will seek from a customer or from a seller regarding their customer relationships?

Mike Harvath  25:52

Yeah, it’s super important that you’re transparent with your representation warranties in the purchase agreement. I say this in general, with any deal, part of what buyers can ask you to do is to represent that the business is in good condition, that the financials are accurate, that the customer contracts are, in fact, factual, that you have not received notice from a client about termination that they don’t know about. I mean, there’s a bunch of things right, and you’ll need to work with your lawyer to make sure that what you’re representing and or warranting in the business is accurate, is 100% accurate. That is about the only way to do a deal effectively, because if for whatever reason, you withheld information as a seller or or misrepresented information in a deal, you’re going to have an unhappy buyer, or you’re going to have an unhappy insurance company that warrantied that buyer, that the reps and warrants were accurate in your deal. Become more and more common for buyers to seek reps and warrants insurance to help mitigate their risk in a deal. Because you know, you may represent something as being accurate and you may not have knowledge of the fact that it wasn’t accurate, for example, and certainly in situations like that, the reps and warrants assurance no one would have knowledge of it’s not accurate. And the reps and warrants insurance policy would oftentimes cover that. So it’s become very interesting and used a fair amount for insurance companies to warrant to provide reps and warranty insurance. Part of why they do that, however, is because of the very low likelihood that there’s going to be a reps and warrants violation in a deal. So it’s kind of, I don’t want to say it’s easy money for insurance company, but it’s certainly a low risk that there’s going to be an issue. Matter of fact, in doing this at revenue rocket for the last 24 years, I can’t think of a deal we help facilitate where there’s been a reps and warrants violation and and part of that is because sellers are, you know, take alongside their lawyer pretty seriously that whatever they’re representing or warranting in a purchase agreement is absolutely accurate. And if you do that, then you really have nothing to be worried about in a violation, the only time you have a problem is when, as a seller, you’re not putting forth all the information or the accurate information pursuant to the descriptions in the purchase agreement concerning reps and warrants.

Ryan Barnett  28:39

Right, that makes that makes sense. Yeah, it makes sense. On the the insurance company reps and warrants, is not going to help concentration, but it may help the the documentation, or at least that the successful transition, or to understand what’s needed in understanding of a customer fully.

Mike Harvath  28:57

And I’ll bring that just make that point, you know, I wanted to just kind of ground it with that point that, you know, customer concentration issues are not in any way mitigated. Risks are not mitigated by reps and warrants, insurance or reps and warrants language. You know, a buyer, of course, is going to ask for a very specific reps and warrants pursuant to that client, likely that they haven’t provided you any notice, for example, that they’re going to terminate, that you’ve, you know, had a relationship for a certain period of time, that you believe that that war, you know, that relationship is going to continue, blah, blah, blah, blah, right? There’s going to be a variety of language around representing and warranting that that customer is in good standing, any customer is in good standing, but particularly those that are concentration risk. But if you’re accurate about how. Present that information and warranty it and represent it. There’s no There’s no, no more risk to you than you know any other thing. The biggest problem becomes is if you know that this something about that client relationship that you don’t disclose, like they’re going to put out your relationship to a bidding process in, you know, six months, and you don’t disclose that, and it comes to be that, you know, it happens, and you lose the business well, you know it’s a case to be made that you probably weren’t fully transparent in your reps and warrants, and there’s a violation. So just need to make sure. Back to my point, you need to be fully transparent and accurate.

Ryan Barnett  30:47

Yeah I think that’s a great point. Mike, this has been extremely interesting and helpful. I would say if as to summarize a bit of what I heard, I heard that keeping customers post transaction is absolutely one of the most important things for both buyers and sellers. So anything you can do to further the relationship, have contracts in place, have the right people in place, and have a transition plan is important so buyers get to know your sellers, customers, if there are and sellers be frankly, be aware that buyers are going to go deep here, and so understand that that’s going to be critical towards getting a deal done. I heard if you’re if you you can mitigate a price purchase decrease, if you’re able to and willing to use structure within a deal, I think that’s critical to look at. Sellers should be on plan for an earn out. I think it’s fair to say that when customer concentration gets per past a certain point, you’re going to put some real dollars at risk to make sure that that transition, that customer is transition. Mike, you had mentioned a year time frame, I think that we have seen up to three years and even beyond some of these deals. So it’s a matter of be prepared that deal structure may be impacted more than enterprise value alone. And then we talked a bit about how those deal structures can help out sellers and buyers, but also how reps and warrants are going to be used by by the buyer, and you, as the discloser and seller, will need to be truthful and accurate to the best of your ability to make sure that what the buyer is getting is indeed what the buyer knows that they’re getting. So great concept. Again, we see a lot of customer concentration. It’s not uncommon to see 40, 50% and there are very, very positive ways that we have gotten deals done that have customers with that concentration, as we talked about today with that Mike, I’ll let you to it any for any future podcast again, listeners, please let us know info@revenuerocket.com, you can see our current deals at revenuerocket.com/current-deals and subscribe to our newsletter at that exact same place for other deals that are coming out in IT services world. Back to you. Mike,

Mike Harvath  33:22

All right, Thanks, Ryan. With that, we’ll tie ribbon on it for this week’s Shoot the Moon podcast. Encourage you all to tune in next week when we unpack additional topics of interest and the sort of M&A world of IT services, as well as unpack growth strategy and culture considerations as you work to grow your technology enabled services company make it a great week and tune in next week. Thanks a lot.