Is Inventory Included in the Valuation and Sales Price?

For many experienced Business Intermediaries, this is not the first time this question has been asked. While most valuation and recasting elements of our profession are very straightforward, how inventory is incorporated in a valuation and business sale varies considerably. This is an issue where the phrase “it depends” is appropriate.

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.

In 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 breakdown of those 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, grocery, liquor, 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 average amount of inventory is for a particular business can be established through inventory reports, historical sales, and balance sheet data.

Lender financing is often utilized to fund acquisitions and in these situations it will be important for the transaction to cash flow for the buyer. 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 included. A calculation for “excess” inventory may be warranted, where a normal 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 standpoint of the buyer’s post transaction cash flow analysis. Based upon historical cash flow, sales price, and amount being financed, can the proposed transaction enable a buyer to obtain financing based upon prevailing loan packages? The post debt service cash flow must be adequate for the buyer to live on. For some transactions the total amount requested to pay “for everything” could be untenable from a buyer cash flow perspective.

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. A couple of examples, include:
• Seller consign the excess inventory to the buyer (pay as sold basis)
• Current owner sells off excess inventory prior to transaction. (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 – 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, 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
• (used) Motorized Vehicle Dealerships
• 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.

It is clear that 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. 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.