I have been told different things - is the amount of inventory added to the purchase price when selling a business - or is it included in the price? Or should I structure my selling price excluding the inventory and take back a note? It seems as if when I add the inventory amount to the purchase price it seems too high for some reason.
Some types of businesses are sold with inventory added into the selling price, some are not. The type of business, (C corp, S corp, LLC, and Sole proprietorship) and the financial reporting method (cash or accrual) also determine the procedure. If the business has inventory it must report using the accrual method which means the inventory will be listed as an asset on the financial statements.
If your inventory is listed on your financial statements I would recommend that you not sell it as a separate entity and do not offer a separate note. The more cash you can get upfront in the sale the less risk you have in getting the most out of your business. It also would benefit you to get a professional market value business appraisal to determine the exact value of your business. You want to get the best price possible and not over price the business so it would never sell.
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The key consideration in pricing a business when the Inventory is substantial is to consider the total purchase price and how long it would take the Buyer to recover that purchase price. If you were to get bank financing for the purchase, that is how they will look at it. If buyer had a choice of buying a business that requires a large amount of inventory versus one with a much smaller amount of inventory with the same cash flow then buyer would recover his money faster in the second type of business.
The rule I have used is to include a reasonable amount of Inventory in the asking price. This amount being what you would consume for a purchasing cycle. So if you purchase inventory once a month, you would include a month's worth of inventory in the asking price. The excess inventory is to be paid for by the buyer in addition to the business purchase price.
When the amount of inventory is quite substantial then the asking price multiple needs to be adjusted down somewhat to account for this need for extra cash. Offering to carry a note for the excess Inventory is definitely a good way to go. But if you make the loan a short term loan, e.g. one year, Buyer may have difficulty paying back the loan while still making a decent income. There are business norms for different types of businesses regarding how much of the inventory is included. So the answer to your specific question would also depend on how your type of businesses are generally priced regarding the handling of inventory.
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The standard procedure when a broker take a listing, on a small main street businesses, can be with or without the inventory being included in the listing price. Including it actually presents a more honest picture, to the buyer, of what is required to buy and run the business. The reason it gives a better picture, with the inventory included, to a buyer, is because when the buyer looks at the net cash flow figure (SDE) and then compares it with the asking price, the buyer sees that it a high multiple. Let’s take an example. Net cash flow is $100,000. The price without inventory is $200,000 and with inventory is $300,000. The price is 2X without inventory but 3X with inventory. This might make the asking price look too high but in fact that is the real multiple.
The purchase price of any business must include all assets necessary to produce and sell the product. Furniture, fixtures, and trucks are all necessary to doing business. These items can’t be left out or be added as additional buyer costs, because the inventory IS the product itself. The accounting concept that inventory is not required to produce the product because it is the product, throws a small confusion into the subject, which is why it is sometimes not included in the price.
Accounts receivable is another similar issue and should be included in the purchase price because it is required to finance the buyers purchase or there would be no purchase. If standard financing is 30 days, then it is part of the sales expense. May sellers try to keep the accounts receivable and let the buyer finance his own accounts receivable. This is part of the operating expenses of the business and really needs to be part of the total purchase price along with the inventory and equipment.
My suggestion is to consider what the total purchase price will be with the inventory and the accounts receivable both included. If the listing price has either of these excluded, it is of no importance, because you as a buyer can just include them for all your financial calculations. You are buying a going business, not starting a new one. Working capital is part of the investment needed to buy and operate the business.
Look at the viability of the business regardless of how the purchase price is structured. If you buy the business without the Accounts Receivables you must invest that much more money into the business.
I have seen businesses that are making a profit each year but the price is way too high when everything was included in the total price. The business owner had not taken these issues into account when figuring the available profit. There was none. All his profit went back into the business and paying his SBA loan payment. The only way he would reep his reward was to wait 10 years when the SBA loan was paid off or sell the business and get his investment and invested profit back. None of this was ovious to the prospective buyers looking at this business making a taxable profit.
How the listing is structured is not important. What is important is that a prospective buyer and the seller look at the total cost to a buyer including Furniture, Fixtures, vehicles, inventory and accounts receivable. Determine a negotiated purchase price taking all these factors into account and have a win- win deal.
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Good question. It does come up from time to time, particularly in negotiations over a buy/sell contract. If you were told by a broker that the inventory should be included in the price, you probably can guess what he or she was thinking. (Hint: the broker’s commission is based on selling price). But for most businesses, the best idea is to price the business based on standard appraisal approaches, and then add in the inventory as an extra expense. One main reason for this is that a buyer who is looking at the price as a multiple of earnings, will conclude that a "business" price that’s inflated by including the inventory is simply not a good deal.
For marketing purposes, it usually makes more sense to offer the moneymaking machine (the business) at a price that can be justified, and then selling separately, the actual stuff that goes through that machine. There are a number of ways to structure the inventory part of a transaction, incidentally. Faster moving items might be purchased at cost at close of escrow and the items that don’t move very well might be "consigned" to the buyer by the seller. Consignment items are not paid for by the new business owner until he or she sells them.
An exception of course is a business in which inventory is a very small part of the company’s value and is subject to constant changes as orders are filled and things are then sold. Some restaurant brokers recommend that their sellers include the inventory in the sale (and in the asking price). It’s a gesture of goodwill that can set a productive tone for negotiations.
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The inventory is typically added to the price of the business as a value to be determined. Like, (a) "business priced at $250,000 plus inventory" Or (b) it could also state the pre-determined value in the price, "The price of $350,000, including inventory, valued at $100,000." In this scenario it would be recommended that some verification of the actual value be determined through the taking of a physical inventory. If (a) is selected, the amount of the inventory would not be know exactly until the time of taking the inventory.
As an allocation item it is a single line item with the value you as you and the seller state it to be.
Additionally, the time for taking the inventory should be as close to the transfer date as possible. Adjustments to the inventory will need to be tracked from the point of physically taking the count.
I would recommend that if the buyer believes he will be negotiating the inventory value it should be done timely, allowing for ample time for settling the terms of the adjustments before closing. An early inspection of the inventory might be advisable and will help in determining if further negotiations are going to be considered.
Paying for the inventory is also a negotiable choice. In some cases the inventory might be floored or otherwise financed. It is possible to assume this or even ask the seller to cary back the inventory value.
It is most important to realize that inventory, as is with each category of value is a point of negotiation. The value should be negotiated based on replacement value or original purchase value. However, the current marketability, shelf time and condition should all be taken into consideration. Lastly, consider the uniqueness of the inventory and seek informed opinions from people in the field. What ever method is chosen it is always best when it is the most suitable to serving the needs of the principals of the transaction.
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