Q: We are currently performing due diligence on a small manufacturing company. Everything seems to be in good order, and the business is very profitable. Our biggest concern is that nearly 60% of the sales are to just one retailer. There are no indications that there are any problems with this account, but obviously the business would suffer dramatically if it were to lose this customer.
What protections can we include in the deal? How should we factor this risk into the purchase price?
A: Oh boy! Customer concentration issues, especially in the manufacturing sector, make me very nervous.
You’ll want to attack this deal from two perspectives:
- What is the possibility that the client can shift to an offshore manufacturer or competitor
- What relationship, contractual or otherwise, is currently in place between the client and the business? My guess is that any contract can easily be terminated but it’s worth knowing.
Assuming that you do your research, and are confident that the business with this one client will continue, your best earnout scenario will be to establish the price and have a holdback of at least 50% dependent upon the business’ ability to maintain the client for at least one year post closing. You must also understand that the seller will have some legitimate concerns about this. For example, if you take over and mess up the business, you certainly cannot expect the seller to forfeit the money, right?
Have you determined what is that keeps this client buying the products?
Is there anything proprietary about the product?
On a final note, you’ll want to evaluate what opportunities exist for you to expand the business.