Buying a Business With Concentration Risk

What lenders will ask, and how to hedge it

One customer, one supplier, or one referral source can quietly decide whether your deal gets financed. Here is how I have seen buyers and sellers structure around it.

But first, a quick note:

Last week I hosted a live webinar, Approaching a Deal With Clarity, with Eric Hsu, Esq. of Clear Focus Law and Chris Barrett of Midwest CPA on how to do enough diligence before LOI to avoid spending real money on a deal that was never going to survive. If you could not join us live, here is the recording: Watch the replay here​

Now, to this week's topic.

Customer concentration is the most common reason a deal that looks financeable on the surface gets a much harder look once it reaches a credit officer. I have had a version of the same conversation on several deals in just the last few weeks.

A buyer finds a good business at a fair price, builds a clean offer, and then we get to the revenue detail and one customer is driving 30%, 40%, sometimes half of the top line.

The question is always the same: does this kill the deal?

The honest answer is no, not by itself.

Concentration is a risk you manage and structure around, not an automatic decline. If you understand what the lender is actually worried about, and you walk in with that worry already answered, you can finance businesses that other buyers walk away from. This issue is about the specific ways I have watched buyers and sellers do exactly that, including one structure that is underused and very effective: the forgivable seller note.

First, concentration is more than one customer

When buyers hear concentration they picture one giant customer. That is the most common version, but it is not the only one a lender will flag. The forms that come up most often on our deals:

• Customer concentration. One or a small handful of customers make up a large share of revenue. This is the one everyone knows.
• Supplier or vendor concentration. The business depends on a single supplier for the product or input that makes the whole thing work, and there is no easy second source.
• Referral or channel concentration. A medical practice that gets most of its patients from one referring physician group, or a consumer products business that does most of its sales through one online marketplace.
• Geographic or contract concentration. Most of the revenue sits inside one contract, one location, or one agency.
• Key person concentration. The owner is the relationship. Strip the owner out and a meaningful slice of the revenue may leave with them.

Every one of these creates the same underwriting question: what happens to cash flow if the concentrated piece goes away after you close.

The number that makes a lender lean in

There is no single legal threshold, but here is the rough shape of how it plays out in practice. Many SBA lenders start asking real questions once a single customer crosses about 10% of revenue. Once you get into the 25% range and above, concentration stops being a footnote and becomes a central part of the credit decision.

By the time one customer is half the business, the lender is underwriting that customer almost as much as the business you are buying.

None of those numbers are automatic declines. They are the points at which the lender shifts from taking the revenue at face value to asking whether they can rely on it.

What the lender is actually afraid of

Underwriting is not afraid of concentration in the abstract. They are afraid of a specific sequence: you close, the relationship that lived with the seller cools off, the big customer drifts to a competitor, revenue drops, and the debt service coverage that looked comfortable on paper falls below the line right when you are least able to absorb it.

That is the whole fear in one sentence. Everything the credit officer asks for is an attempt to figure out how likely that sequence is and how much cushion you would have if it happened.

From a credit officer's chair

I asked an SBA business development officer at a bank our team works with regularly how their credit team actually treats a concentrated customer when they size a loan. The version worth passing along, paraphrased:

Two things matter in that. The first is that the lender is going to run your deal without the concentrated revenue and see what is left, so you should run that math yourself before they do. The second is that tenure, repeat history, and who owns the relationship can move a deal from hard to financeable even when the percentage does not change.

The questions you will get asked

When concentration shows up, expect a version of all of these. On a recent commercial cabinetry deal, the lender's credit team sent over their first round of questions and one of them was, almost word for word, can the buyer explain why he is comfortable with the customer concentration in the revenue. That question is coming.

Have the answers ready before you submit, not after.

• How long has the top customer been with the business?
• Is there a written contract or a long repeat order history, and does it carry over to the new owner?
• Does the relationship belong to the owner personally, or to the company and its team?
• Is the revenue recurring, or is it project work that has to be won again every year?
• How healthy is the customer itself, and is their own business stable?
• What would cash flow and debt service coverage look like if that customer were cut in half or lost entirely?
• What is the seller willing to do, through transition time or a standby note, to protect you while you secure the relationship?

If you can answer those seven on the first call with a lender, you are already in a different category than the buyer who gets surprised by them.

A few deals I have seen, and what actually worked

I want to walk through a few real situations from past deals, anonymized, because the patterns are a lot more useful than any single rule of thumb.

The first one has always stuck with me. A buyer brought me a transportation and logistics business where more than 80% of the revenue came from two customers, and really one customer once you realized the second was an affiliate of the first. The sellers had a fair rebuttal, which was that those two had been customers for sixteen years. That kind of tenure genuinely matters.

On its own, though, it does not put a lender at ease, because the goodwill of the business depends on those relationships staying strong after the sale. So the first thing we dug into was how arm's length those relationships really were.

Were they built on the business itself, or were they personal to the seller?

From there we worked through a contingent, forgivable seller note tied to the retention of the key accounts, so that part of the seller's payout depended on those customers staying on after closing. That does two good things at once. It takes risk off the buyer, and it is also a way for the seller to show real confidence in the stability of those relationships. Paired with a healthy seller note on standby and a plan to diversify the customer base after close, that is the kind of deal a lender can get comfortable with.

A second one went the other way, in the best sense. On a manufacturing business, the prior owner had taken one deliberately soft year to work the company out of a customer that had once been half of the revenue. By the time the deal came to us, the top customer was down to roughly 15% and the base was nicely spread, with the most recent years tracking strong.

That single down year looked like a problem on the page until you understood the reason behind it. There the work was mostly framing: a short written explanation of the decision and the rebound, order history to show the new base was durable, and a quality of earnings report so the numbers tied out cleanly for the bank. Concentration that is already being fixed, with the trend to prove it, is one of the easiest versions of this story to finance.

The third is the harder version, and it is worth being honest about. On a project based services business, the top handful of accounts were well over half of revenue, almost none of it was under contract, and the relationships really sat with the owner who was leaving. There was good cash on the balance sheet, but the revenue itself was fragile. That is the deal where the percentage is not really the headline. The fragility underneath it is. The right move there was not to paper over it, but to structure around it honestly, with a larger seller note, a forgiveness feature if the key work fell off, and a sober look at whether the price reflected the risk. That last idea, the forgivable seller note, is worth its own section.

The forgivable seller note, and why it beats an earnout

Most buyers, when they see real concentration, reach for an earnout. The instinct is right: tie part of the price to whether the big customer sticks around. But the structure is wrong for SBA (an earnout is not allowable by the SBA).

An earnout increases the purchase price after close if the business performs, and SBA financing is built around a purchase price that is fixed and known at closing. Contingent payments that move the price up create exactly the kind of uncertainty a 7(a) lender cannot underwrite around, which is why earnouts and SBA loans rarely mix.

A forgivable seller note solves the same problem from the other direction. Instead of paying the seller more if the customer stays, you owe the seller less if the customer leaves. The price is fixed at close, the bank sizes the loan to that fixed number, and a defined slice of the seller note is forgiven, meaning you stop owing it, if a named customer is lost or materially shrinks inside an agreed window after close. Because the only direction the number can move is down, it is a structure the bank and the SBA can work with, and it puts the risk of the concentrated relationship back on the person best able to protect it during the handoff: the seller.

Here is the shape I have seen discussed and used. On a residential services deal where one relationship drove an outsized share of revenue, we worked through a seller note on full standby with a forgiveness trigger built in: if that customer's trailing twelve month revenue fell below a defined floor within twenty four months of close, an agreed percentage of the remaining note principal would be forgiven. The seller stayed motivated to transition the relationship personally, the buyer had genuine downside protection, and the note still sat on full standby, so it counted toward the SBA equity injection.

A few things to get right if you go this route:

• Define the trigger precisely. Name the customer or the revenue threshold, the measurement window, and exactly how much of the note is forgiven at what level. Vague triggers turn into disputes later.
• Keep it on full standby. For the note to count toward your equity injection under SBA rules, it generally needs to be on full standby for the life of the loan, with no payments of principal or interest during that period. A forgiveness feature can coexist with that, but the language has to be drafted so it does not break the standby treatment.
• Get your lender and SBA counsel to bless the specific language before you sign. This is not a clause to freelance. The difference between a forgivable note the bank accepts and one it rejects is almost entirely in the drafting.
• Label it correctly in the LOI. Describe it as a reduction mechanism on the seller note, not as a contingent additional payment, so the credit officer reads it as the opposite of an earnout rather than mistaking it for one.

The forgivable seller note will not fit every deal, and it is not a substitute for a business that simply cannot cover its debt without the concentrated customer. But on a deal where the concentration is real and the seller genuinely believes the relationship will survive the transition, it is the cleanest way I know to get the buyer and the seller on the same side of that bet.

Other ways to hedge, in one place

Pulling the levers together, here is the full toolkit I walk buyers through when a target has real concentration:

• Run the stressed cash flow yourself, with the top customer cut by half and again at zero, and lead with that number if the deal still services debt.
• Get the contracts or a documented repeat order history assigned and transferred to the new owner.
• Build real seller transition time and warm customer introductions into the deal, especially when the relationship is personal to the owner.
• Use a seller note on full standby for cushion, and add a forgiveness trigger when concentration is the central risk.
• Consider bringing a key operator or relationship holder in as a small equity partner so the person who controls the at-risk revenue has skin in the game.
• Order a quality of earnings review that specifically addresses concentration, tenure, and revenue durability, so a third party signs off on the story rather than just you.

When concentration is fine, and when it is not

Concentration is most financeable when the relationship is old, documented, owned by the company rather than the person walking out the door, and when the business still covers its debt even if you assume the worst about that customer. In that situation a high percentage is a feature you can defend.

It is most dangerous when the relationship is new, informal, tied to the departing owner, and when the entire deal only pencils if that customer stays exactly where it is. That is the deal where the percentage is not the problem. The fragility underneath it is.

The buyers who win these deals are not the ones who avoid concentration. They are the ones who walk in already knowing which of those two situations they are in, who have built the answer, and where it makes sense the seller note structure, into the offer before the lender ever has to ask.

Thanks for reading!

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Until next time,

Matthias Smith

President, Pioneer Capital Advisory

​www.pioneercapitaladvisory.com​
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Disclaimer: The information in this newsletter is for informational purposes only and should not be considered legal or financial advice. Business buyers are encouraged to consult with their legal counsel and accountant to ensure the proper structuring of their transactions and to fully understand the tax implications of seller financing.

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