This is most likely not the first time a professional who is involved in business sales and acquisitions has contemplated this question. While most valuation and recasting elements of our profession are very straightforward, how inventory is incorporated in a valuation and business sale can vary considerably. This is an issue where the phrase “it depends” is appropriate.

It’s probably appropriate to define “inventory” as it’s referred to in this article. “Inventory” is defined as saleable goods purchased by the business for resale. However, when considering the definition of owner benefit or seller discretionary cash flow the AMOUNT of inventory expected to be included is the amount of inventory that was required to generate the profits being represented.

This raises an interesting, double-edged, point. How do we know if there is an excessive amount of inventory? How do we know if there is a shortage of inventory? The only way to start evaluating this issue is to start with the balance sheets looking at beginning and ending inventory values. If there is less inventory at the end of the period, profit is likely over stated (because cash was not re-invested into inventory). If ending inventory is higher than beginning inventory profits are likely understated (as profit was used to increase the inventory on hand).

However, those are not the only material considerations. You must contemplate the quality (saleability) of the beginning and ending inventory as well. If you ended the period with more inventory, but it was all unsellable an adjustment needs to be made to reconcile back to sellable inventory.

The guidelines and considerations for addressing inventory can be different depending on the industry, type of business, and amount of inventory involved when both valuing and selling a business.

Other situations that require individual consideration of the circumstances:

  • A material amount of inventory was stolen, spoiled, damaged or otherwise became unsellable
  • Seller purchased large quantities of inventory that within the period that was subsequently written off
  • Value of inventory at cost has gone up or down significantly since purchasing
  • Margins on the inventory have increased or decreased significantly over the review period
  • Some aspect of the inventory has made it more or less valuable for example a free extended manufacturers warranty

In main-street asset sale transactions, the most common structure is for the seller to retain cash & accounts receivable, satisfy accounts payable and transfer all assets free and clear of any liens/encumbrances as of the day of closing. The buyer typically acquires all assets necessary to operate the business and these are normally included in the multiple of adjusted earnings derived through the income approach valuation method. Valuing a business via a multiple of adjusted cash flow has little relevance unless it is accompanied with a detailed list of the assets which are included in the sale. Setting aside for now, those industries where inventory is significant in terms of value (jewelry stores, automobile dealers, etc.), a buyer should expect to receive some component of inventory included in the transaction price. Ultimately, the formula and structure needs to pass a reasonable person test and business inventory can be a grey area for many practitioners in our industry. Determining what an appropriate amount of inventory is for a particular business can be established through inventory reports, historical sales, and balance sheet data. This is further complicated when the business’ sales are cyclical.

Lender financing is almost universally used to fund acquisitions and in these situations it is required that the transaction cash flow for the buyer while providing a living wage after debt service. For certain transactions, the value of inventory is very high in relation to the value of the business and it might be challenging for the buyer to cash flow the transaction if all inventory was added to the purchase price based on the income approach. A calculation for “excess” inventory may be warranted, where a nominal amount is included in the multiple and an excess component is added to the purchase price.

When preparing a business for sale it is important to evaluate the numbers from the perspective of the buyer’s post transaction cash flow. Based upon historical cash flow, sales price, and amount of debt service, can the proposed transaction enable a buyer to obtain financing based upon prevailing lending guidelines? The cash flow after debt service must be adequate for the buyer to live on. For some transactions, the total amount required to pay “for everything” often exceeds a buyers ability to pay ordinary personal expenses after the associated debt service.

Selling a business involves a number of challenges and mitigating known obstacles upfront will provide an easier path for all parties to complete the transaction. Inventory should never be a stumbling block to closing a sale. For businesses where excess inventory is present there are a number of solutions available. Several examples, include:

  • Seller consign the excess inventory to the buyer (pay as sold basis)
  • Seller remove slow moving and/or obsolete inventory from transaction (or discount cost)
  • Seller return inventory to vendors as permitted
  • Seller sells off excess inventory prior to transaction typically at a discounted rate. (Depending upon how this is executed, it could be potentially detrimental to the new business owner should products be sold at below market rates to established clients)

In a perfect world, brokers and sellers should be performing a comprehensive assessment of inventory before listing a business for sale. Understanding the quality of inventory under roof and determining if the quantity is in balance with historical sales are worthwhile exercises when evaluating a business for sale.

Determining the following ratios and inventory characteristics at an early stage will pay dividends down the road for all parties:

  • Turn Rate by product category – both historical to the business and a comparison to the industry.
  • Number of SKU’s – understanding the top sellers and poor performers.
  • Salable/Obsolete – damaged, expired, spoiled, seasonal, obsolete.
  • Cost – prevailing market cost vs. cost on the books.

This assessment process enables all parties to have an accurate depiction of the key product sales and the appropriate inventory that should be held by the business. Performing this process early in the engagement enables all stakeholders (seller, buyer, lender) with time to make the logical decisions to correct any inconsistencies or develop solutions to handle excess inventory.

Lastly, there are a variety of industries that are valued differently, especially those that carry significant inventory. Some of the more notable examples include:

  • Jewelry Stores
  • Grocery Stores
  • Motorized Vehicle Dealerships (used)
  • Liquor Establishments
  • Large Apparel Stores

For brokers who have expertise in these markets, it is generally understood that not all of the inventory is included in the valuation multiple. In some cases, none of the inventory is a component. For these situations, it is acceptable for the inventory (some or all) to be added on top of the industry specific multiple used in the valuation. Discussing specific valuations is tangential to this article so it is advised that the traditional professional resources are utilized by the advisor to properly value these inventory intensive businesses.

Getting lenders onboard early is recommended. According to Steve Mariani, President of Diamond Financials Services, when considering larger inventory levels and maybe even excessive, this value in the transaction is sometimes shared amongst buyer, seller and lender. Meaning that first we must determine usable inventory and turn rates as the above describes and then back into the amount that CAN be included in the transaction that still allows for correct lender coverage ratios and an ultimate financing approval. This “acceptable amount” must also allow for the correct operation of the business and not leave a buyer in need soon after closing unless the appropriate amount of operating capital was included for the replacement purpose.

It is clear there are a myriad of considerations addressing the inventory issue in a business for sale. The goal of this article was not to provide a solution or valuation methodology for each industry or specific circumstance but to address some of the avoidable pitfalls related to this topic. Having a large inventory, in some cases, has clear logic behind it and advantages to the buyer, who acquires it. In most cases, it comes down to what the buyer and markets are willing to accept as market changes and cash flows ultimately determine the final selling price. Performing an assessment of the inventory make-up, comparing with industry guidelines, and developing creative solutions to satisfy the goals of both the buyer and seller are recommended to achieve a successful transaction.