Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The Representation That Cost a Seller 45 Million
Transcript
- Lucas: So we've talked a lot about working capital pegs, earnouts, escrow mechanics. But here's one that rarely gets the attention it deserves until it's too late: the customer concentration representation. And I've got a case that cost a seller forty-five million dollars. Luna: Forty-five million. That's a whole company for some people. What happened? Lucas: So picture a mid-sized software company. Let's call it Northwind Analytics. Sold for a hundred and twenty million. The purchase agreement had a standard-ish representation that said the company had no 'material customers' except those listed on the disclosure schedule. The schedule listed a handful, none above fifteen percent of revenue. Clean enough on its face. Luna: But the actual customer mix was different, right? Lucas: Exactly. One client had quietly grown to thirty-five percent of revenue. Not through any single contract surge, but through a series of renewals and add-ons over two years. The seller's CFO knew the number, but the data room just had the standard revenue breakdown by customer, which they never updated after the last fiscal year-end. Luna: And the buyer didn't catch it during due diligence? Lucas: They should have. But the buyer's team relied on the representation and the schedule. They did the typical sampling, saw the top five customers, and the percentages were all within the disclosed range. The problem was the representation didn't define 'material customer.' It just said no customer represented more than fifteen percent of revenue, which was true at signing. But a year after closing, when that big client threatened to leave, the buyer went back and argued that the representation was breached because the definition of 'material' should have been about dependence, not just percentage. Luna: So the buyer turned a customer concentration issue into a reps and warranties claim. How did they get forty-five million out of it? Lucas: The buyer claimed that the undisclosed concentration materially affected the future cash flows, and they used an independent valuation expert who said the company was worth forty-five million less because of that dependency. The indemnification clause had a cap of fifty percent of the purchase price, and there was no basket, so the full amount was claimable. The seller's escrow was only ten million, so they ended up paying the rest out of pocket. Luna: Ouch. And I bet the seller thought the representation was fine because the numbers were technically accurate at the time. Lucas: Right, and that's the trap. The representation was written as of signing, but the buyer argued it implicitly warranted the situation at closing too. And because the definition of 'material' was vague, the arbitrator had room to side with the buyer. This is a perfect example of why you need to define your terms precisely in the agreement. If they'd said 'material customer' means any customer representing more than twenty percent of trailing twelve-month revenue, and they'd updated the schedule at closing, the claim would have collapsed. Luna: So the real lesson is in the drafting. But also in due diligence. Why didn't the seller's own CFO flag this? Lucas: That's the part that gets me. The CFO knew the number. But they didn't think it was a problem because the customer wasn't new, and the revenue was growing. They didn't appreciate that the representation turned a business risk into a contractual liability. There's a gap between what management thinks is material and what the agreement says. And when you're selling, the buyer's definition is the one that counts. Luna: It sounds like the disclosure schedule is where the seller could have protected themselves. How do you handle that in practice? Lucas: You list every customer that even comes close to the threshold, and you err on the side of over-disclosing. Some sellers worry that listing too many customers will scare the buyer or lower the price. But the cost of an unlisted customer that turns out to be material can be catastrophic. I've seen sellers disclose customers at ten percent of revenue just to avoid this exact fight. And buyers, honestly, they usually accept it because it's better to know the real risk profile. Luna: And what about the buyer? Is there a lesson for them too? Lucas: Absolutely. Buyers should never rely solely on a representation when the data is available. If you're buying a company with significant customer concentration, run the actual revenue by customer for the last three years. Don't just sample. The buyer in this case could have caught it with a simple query of the company's accounting system. But they got complacent because the representation looked clean. In the end, they won the claim, but they also spent two years in arbitration and probably a few million in legal fees. And they had a very unhappy seller who was shouting breach of good faith. Luna: Good faith, right. But in the end, the contract won. It's a reminder that reps and warranties are only as good as the definitions behind them. Lucas: Exactly. And that's why I wanted to bring this up. We've covered so many traps, but this one is subtle because it's about a representation that seems straightforward. You read it and think, 'of course we have no material customers beyond what's listed.' But if you haven't defined 'material' and updated your data at closing, you're leaving a door open. And the indemnity clause is what makes it dangerous. The cap, the basket, the survival period—all of that matters. Luna: So if you're a seller listening, what's the one thing you should do before signing? Maybe check your customer concentration numbers against the actual agreement language? Lucas: That's the first step. But also, have your counsel stress-test the reps and warranties against your real data. If there's any ambiguity, fix it in the disclosure schedule or amend the definition. And if you have a customer that's a big chunk of revenue, consider whether you need a carve-out or a specific disclosure. It costs nothing to be thorough in the schedule, but it can save you millions in a post-closing claim. Luna: And for buyers, I guess it's a reminder that due diligence is about more than checking boxes. You have to look at the underlying data, not just the representations. Lucas: Right. And that's really the core of this episode. It's not about the forty-five million per se, but about how a single vague word in a contract can turn into a massive liability. 'Material' is a loaded term, and it means different things to different people. In an M&A context, you have to define it with precision, or you're leaving the outcome to an arbitrator who doesn't know your business. Luna: It's like that arbitration clause we talked about in episode 171, where the seller's best friend was an independent arbitrator. Here, that arbitrator became the seller's worst nightmare because the contract was ambiguous. Lucas: Exactly. And that's why we keep coming back to the same theme: the devil is in the definitions. You can have the best business in the world, but if your purchase agreement has a hole, you're exposed. This is where a good M&A lawyer earns their fee. They should be asking, 'what does material mean here? What happens if this customer leaves? What's the survival period? What's the cap?' If they're not asking those questions, you need a new lawyer. Luna: And I imagine that's also where you see the difference between a seller who's done this before and a first-timer. The first-timer might sign anything just to get to closing. Lucas: Absolutely. Experienced sellers know that the post-closing period is where the real risk lies. They're the ones who insist on clear definitions, tight caps, and a disclosure schedule that leaves no stone unturned. They also push for a 'materiality scrape'— you know, where the reps are qualified by materiality, and the indemnity only applies if the breach is material. That was actually the subject of one of our earlier episodes, the materiality scrape trap. If Northwind had had that, the buyer would have had a much harder time claiming the full forty-five million. Luna: So the materiality scrape could have protected them here. But it's also a double-edged sword, right? Because if the rep is scraped, the buyer might argue that the threshold is lower for a claim. Lucas: Right, it's a negotiation. You have to balance the seller's desire to limit exposure with the buyer's need for certainty. But in this case, even a simple definition of 'material' would have helped. The buyer's argument was that the concentration was material because it affected value. If the contract had said 'material' means more than twenty-five percent of revenue, they would have had no case. Luna: And what about the survival period? How long did the buyer have to bring this claim? Lucas: Typically, reps and warranties survive for twelve to eighteen months. In this case, I believe it was eighteen months. The buyer discovered the issue within the first year, so they were well within the window. But if the survival period had been shorter, or if there was a 'knowledge qualifier'—meaning the seller only reps to their actual knowledge—the outcome might have been different. The CFO knew, but did the CEO? The contract didn't have a knowledge qualifier, so it was an objective breach. Luna: So it's not just about what you know; it's about what the contract says you're responsible for. And in this case, the seller was responsible for a customer concentration they probably didn't think twice about. Lucas: Exactly. And that's the thing that keeps me up at night for sellers. They spend so much time on the valuation and the headline price, but the real money can be lost in the fine print. This forty-five million dollar claim is a perfect illustration. The seller probably celebrated the hundred twenty million, then a year later they're writing a check for forty-five million. That's a third of the purchase price gone. Luna: It's brutal. But it's also a story that can save someone else from the same fate. I think we should tell our listeners to go back and review their own customer data before they even start marketing the business. Maybe even do a mock due diligence on themselves. Lucas: That's a great idea. And it's something you can do without a lawyer. Just pull your top customers and see if any of them represent a significant chunk of revenue. If they do, think about how you'd disclose that to a buyer. And then talk to your lawyer about how to draft the representation to protect you. It's a small investment of time that can save you millions. Luna: And for our listeners who are thinking about buying, the lesson is clear: don't rely on the reps. Do the work. The data is right there in the CRM. It's not that hard to run a report. But a lot of buyers skip it because they're in a rush to close. That's a mistake. Lucas: Absolutely. And that's the kind of advice we like to give on this show. It's about being a smart operator, whether you're on the buy side or the sell side. You have to understand the risks and take steps to mitigate them. This isn't about being paranoid; it's about being prepared. Luna: And speaking of being prepared, I know our listeners appreciate these deep dives. And if you find these conversations helpful, you know what, if you've ever thought about supporting the show, we keep it ad-free, and listener support is what makes that possible. There's a link on our website, buy me a coffee dot com slash fexingo. It's a small way to keep us going. But we'll get back to the deal talk. Lucas: Yeah, thanks for that, Luna. And honestly, it's because of listeners like you that we can spend the time to unpack these cases properly. But back to the topic. So, we've talked about the seller's perspective and the buyer's perspective. But there's another angle: what about the role of the financial advisors in this deal? Did they have a responsibility to catch this? Luna: That's a good question. I mean, the sell-side advisor is supposed to prepare the company for sale, which includes making sure the data room is accurate and that the reps are supportable. But in this case, the advisor might not have been aware of the concentration because the CFO downplayed it. There's a question of alignment: the advisor gets paid on closing, so they have an incentive to get the deal done, not necessarily to protect the seller from post-closing claims. Lucas: Right. And that's a broader issue in M&A. You have to look at who's really looking out for your interests. A good sell-side advisor should be as paranoid as a buyer's lawyer. They should be stress-testing every number and every representation. But often they're just focused on getting the deal across the line. That's why sellers need to have their own legal counsel review the reps and warranties with a fine-tooth comb, not just rely on the advisor. Luna: And I'm guessing that's also where the concept of 'knowledge qualifiers' becomes important. If the seller had insisted on a knowledge qualifier, then the buyer would have to prove that the seller actually knew about the concentration. In this case, the CFO knew, but maybe the CEO could claim ignorance. That could have limited the claim to the CFO's knowledge, but still, it's a risk. Lucas: Exactly. And that's why the negotiation over reps and warranties is so detailed. You're not just talking about the definition of 'material'; you're talking about who's on the hook and for how long. The buyer wants broad coverage, the seller wants narrow. The final language is a compromise, but it has to be clear. The worst thing is ambiguity, because that's what leads to arbitration and these massive claims. Luna: So, to wrap it up, the key takeaways are: define your terms, over-disclose, stress-test your data, and don't rely on reps alone. That sounds like a good recipe for avoiding the customer concentration trap. Lucas: I couldn't agree more. And I hope this episode helps someone avoid a forty-five million dollar mistake. If you're in the middle of a deal right now, take a look at your own customer concentration. It might be the most valuable thing you do all week. Luna: Thanks for listening, everyone. We'll catch you on the next episode of The Acquisition Talk.