If inventory is an asset of the business, why is it treated differently from other assets in setting the business value and conducting the transaction?
The physical assets of the business that produce income are often called the “FF&E”—furniture, fixtures, and equipment. This FF&E are tangible and are different from other intangible assets such as trade name, intellectual property, and goodwill, all of which also produce income for the business. All of these are considered "non-current assets," typically longer term investments that cannot be expected to be easily converted into cash within a period of 12 months.
While inventory is also a physical or tangible asset, it differs from the FF&E and the intangible assets in that inventory is part of the "current assets," the goods and materials consumed and converted in one way or another into the product or service produced by the business for resale to generate income. (Think the groceries in a restaurant rather than the stove, refrigerator, tables, and chairs.)
Inventory, depending on the type of business, is further delineated as raw materials, work in process (“WIP”), and finished goods. A retail store, for example, would typically have only finished goods inventory; a manufacturing company, on the other hand, would have raw materials, WIP, and finished goods.
For purposes of valuation, I generally calculate the FF&E as contributing to enterprise value by the amount it would cost to replace them, regardless of their initial cost or their current depreciated “book” value.
Inventory, however, is calculated at the lower of its initial cost or the current cost in the market, with increasingly greater reductions of value the longer the item has been in inventory. Since inventory is intended to be converted to cash through sales in the short term, the longer it sits in inventory the more it costs to hold it and the less likely it will convert to cash, hence, the lower value.
So, how does this affect valuation and the transaction?
Typically, the business is valued without inventory for a variety of reasons, one of the most important being that inventory can fluctuate from month to month, even from day to day. So, most businesses are sold at a price plus inventory, at a value determined by negotiation between the parties, depending on the condition and age of the inventory and on it not exceeding the amount that will be needed in the relative short term. (Think of a restaurant with six month’s worth of frozen food; it would take too long to convert to cash and, therefore, its value would be discounted significantly.)
Furthermore, in a bulk sale transfer—which is most small business sales, the inventory is being bought and held for resale, and typically is not subject to sales tax at the closing. The amount allocated to the FF&E, however, is not being held for resale and would incur sales tax liability at the closing.
It's important to clearly understand the difference between the inventory and the other assets of the business. Otherwise confusion regarding value and sales tax liability can derail an otherwise good deal.
And, quite often, the parties agree on a good faith estimate of inventory value at or near the time of closing, based upon business records or a superficial or partial inspection, rather than an exhaustive, time-consuming, item-by-item physical count of each and every item.
Recently, we sold a real estate staging company that places furniture and accessories in homes for sale (and we have another one listed for sale as well). The physical assets of the business were thousands upon thousands of chairs, sofas, tables, dressers, beds, paintings, vases, linens, etc., etc., that the parties kept calling “the inventory.” In order to avoid confusion about the basis for valuation and to avoid “surprises” when it came time to calculate the sales tax at closing, we had to keep reminding the parties that it was not inventory, since it was not being resold; it was the furniture and equipment used to produce income, more like the factory machinery or the restaurant kitchen than like the raw materials or groceries being converted into finished goods.
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