A question was posed to me recently from a business buyer in the BizBen ProBuy Program about how to handle the inventory amount in the purchase price, here's his question:
"How do you handle the inventory amount in the valuation and price of a retail based small business? If the inventory value is high compared to the "value" of the business by itself: Do you add the inventory value to the business value? The price of the business is $195K plus inventory (the inventory amount is just over $125K) - the adjusted net income is $90K. Should the owner be expected to take back a note for the value of the inventory? We don't want to overpay for this business and the inventory amount is stopping this deal from going through. Any suggestions?"
It's easy to see how a situation like this can cause a buyer and seller to disagree about the amount of inventory that should be part of the deal. And both have a point.
From the buyer's perspective, it seems unreasonable to ask for a large investment represented by the inventory, in addition to the investment in buying a California business. Total amount paid for everything can be a figure much greater than is warranted by the expected profitability. In other words, the return on investment, after adding in the cost of the inventory, might not meet the buyer's requirements.
Some Feedback From Our Advisors In The BizBen Network:
"Here is how I dealt with this in the past.
If the inventory amount in comparison to the asking price is too high, the first question I ask the seller is whether the entire inventory is required to generate the existing revenues and cash flow. Sometimes, the sellers tend to overstock and if that is the case during the escrow period of 30 days, the sellers do have the opportunity to sell down the inventory and bring it to a more reasonable amount.
However if the entire inventory is required to maintain the business as is, then I encourage the seller to include half of the inventory in the purchase price and ask the buyer to pay for the other half in addition. For example, in this case I would offer the seller $195K including $62,500 inventory at cost and the buyer will pay for the other half in addition. If the seller does not want to compromise at all (which 9 out of 10 times they will), then I would get the seller to carry all of the inventory or at least half of it for a short period of time (2 years).
I am currently working on a deal that is in Escrow for $625K (import/export business) in addition to $700,000 worth of inventory at cost. I used the approach described above and the seller ended up carrying half of the inventory."
"There are many tangential questions to ask when responding to these questions. Generally speaking however, based on the facts presented, we recommend separating the negotiated selling price and the inventory at cost with small retail business transactions such as yours. Also, there is really no established ratio between the price of the business and the value of the inventory. For instance, we have even sold businesses for just the cost of inventory.
Since inventory seems to be an impediment and a prime concern, I would first focus on the content and the quality issues associated with the inventory to determine if it is current and in balance. Following are some basic suggestions to examine: 1. Look at inventory turnover ratios over the past few seasons and years and compare them to industry norms. 2. Break down sales by classification and inventory by classification in order to analyze if the inventory is properly balanced and funded. 3.Look for seasonal, damaged, old or obsolete merchandise and exclude them from the sale. 4. If you are going to change or modify the direction of the store, negotiate to exclude this merchandise from the inventory. These suggestions and others specific to your business may effectively reduce the inventory.
It's best to negotiate the deal parameters early on so that the seller has ample opportunity to dispose of the inventory prior to closing. Alternatively, you may agree to take excessive inventory at a significant reduction. With inventories of this size, we also recommend that the buyer and seller split the cost of a professional inventory service just prior to the closing date.
Should the owner be expected to take back a note for inventory? Well, there are no expectations because successful transactions are negotiated based on motivation as well as on comfort between buyer and seller. In this environment, seller financing might be the norm in retail business transactions; however, after conducting your thorough analysis and due diligence, I would focus not on the inventory as a negotiating point, rather on a dollar amount and terms that fit your comfort level."
"In response to the Blog question regarding how to handle the inventory on a purchase when the inventory value is high, the reason for the high inventory may be that the seller is prepared for the Christmas season when sales are increased over normal months. If this is the case that you may ask the seller to carry a portion of the inventory until after the Christmas season and make a balloon payment in January.
If the inventory is high due to some obsolete inventory being included, then you might get the seller to agree to discount a portion of the inventory that is obsolete or very slow moving.
In the event the inventory is large in order to fill the retail space in order for the store to look like it is fully-merchandised and not have half empty shelves, then you might be able to get the seller to carry a portion of the inventory (that portion over what is normally sold on a monthly basis) for a short period of time. The seller may require a minimum inventory level guarantee be placed on the note to insure some level of inventory be maintained while the note is in force in the event you default and the seller is required to re-assume the business.
These are just a couple of the ways to handle this situation or hire an experienced business broker who can assist and counsel the parties in this matter."
"Inventory is always a critical factor in retail business transactions, especially businesses like a market, liquor and smoke shop, etc.
The best way of handling this matter is to call a local inventory company that has a state license. They are expert, and most inventory companies have a database. It contains the wholesale prices of most products. And they are updated every week, so buyer and seller don't have to argue about the retail prices or purchase prices.
Most of the time, the inventory value is less then what the seller think. When buyer and seller call the inventory company, the seller and buyer pay half and half.
If the inventory is too much, the buyer can do two things. First, he can ask the seller to reduce the inventory while they do the escrow process. Second, the buyer can ask the seller to carry the price for the inventory. Nowadays, under a buyer's market, many sellers are willing to do that."
"Inventory is handled in many different ways depending on a multitude of variables. Depending on the type of retail store, some inventory may be of little to no value due to obsolescence. For example, the electronics industry changes so rapidly that inventory more than a few months old may have already been replaced with newer models. The inventory in retail clothing stores is quite seasonal and new fashions and designs are created constantly. On the other hand, in other types of retail stores, unless the inventory is perishable or has been sitting for years, it is probably quite saleable.
If the owner has any type of inventory system, he/she may be able to print reports for you to show you when certain products were last sold and when they were last reordered. However, in the price range you are discussing for this retail store, it is doubtful that the owner maintains that level of inventory control. Ultimately you need to find a way to determine how much of the inventory is useful and saleable as you don't want to purchase obsolete merchandise.
It is important to ask questions of the owner. How did he/she arrive at $125,000 for inventory? Can that value be substantiated? Is that value cost basis, wholesale or retail? Does the seller have vendor invoices or receipts for the merchandise? These invoices and receipts will also help you identify the actual costs and how long merchandise has been sitting around.
One resolution may be to purchase a portion of the inventory. Go through the store and figure out what merchandise you would like to purchase at cost and exclude the remaining inventory. Suggest that the owner have a sidewalk sale prior to close of escrow to sell off the items you did not elect to purchase. Another possible solution is to ask the seller to carry a note for half of the inventory value. You may also offer to buy the entire inventory for some percentage of the substantiated cost basis. If you determine that obsolescence is not an issue for this particular type of retail business, you may want to purchase the entire inventory at the seller's cost. Perhaps you can buy half at cost and have the seller consign the other half. There are many ways to work it out. You just have to be clear on how the value was derived and if the merchandise is still saleable."
"The Fair Market Value of inventory can be added to the value of a retail business, but the critical issue is to ensure that there is a physical inventory count just prior to closing, to determine the Fair Market Value. As a general rule, the inventory should be "fresh, clean and saleable". This means that inventory that has been sitting for a period of time should be discounted or in some cases excluded from the inventory valuation. To avoid nasty surprises at close, the buyer and seller could do a physical inspection of the inventory several weeks prior to close, and reach an understanding as to the process that will be used to classify fresh, clean and saleable. But the physical stock "take" should still be done at close."
About: Peter Siegel, MBA is the Founder & Senior Advisor (ProBuy & ProSell Programs) at BizBen.com (established 1994, 8000+ California businesses for sale, 500 new & refreshed postings/posts daily) working with business buyers, small business owners/sellers, business brokers, agents, investors, and advisors). Reach him direct at 866-270-6278 to discuss the BizBen ProBuy Program or the BizBen ProSell Program and strategies regarding buying, selling, (or financing a puchase of) California businesses.
Categories: BizBen Blog Contributor, Business Valuation Issues, How To Buy A Business, How To Sell A Business