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.
About This Contributor: Tim Cunha is a business broker in the San Francisco Bay Area. He has managed and sold several businesses of his own, Tim offers business sellers extensive personal experience and professional expertise in building business value, planning a successful exit strategy, "packaging" and promoting the sale, and coordinating a successful and profitable transition. Phone Tim Direct at 650-600-3751.
|Helpful Resources To Assist In Selling And Buying California Businesses|
|Diane Boudreau-Tschetter: Escrow And Bulk Sale Services
California Business Escrow, Inc. is a full service independent escrow company serving all of California and has expertise in a wide range of escrows. Our team prides itself on providing an exceptional escrow experience. For more info phone Diane Boudreau-Tschetter at 888-383-3331 or 209-838-1100.
|Mark Chatow, Esq.: Legal Services For Buying, Selling Businesses
Mark has a broad range of small business purchase & sale experience from analyzing potential acquisition targets to successfully guiding buyers and sellers through the purchase & sale of small businesses. Mark can assist with contracts, negotiations, legal matters, etc. Reach Mark at 949-478-8393.
|Joe Sandbank, Esq. - Legal Services
I have provided legal counsel to business buyers, sellers and brokers for over 17 years. With prior experience as a business broker and SBA loan officer, Joe brings both a practical and legal approach to all aspects of the business acquisition process.
|Elizabeth McGovern: Escrow Services - SF Bay Area
McGovern Escrow Services, Inc., is a leading independent escrow company. We are a trusted partner with our clients, assisting them through the tangled bulk sale & liquor license transfer process. We provide attentive, quality & innovative customer service. Phone Elizabeth McGovern at 415-735-3645.
|Ranvir S. Sandhu, Esq. - Legal Services For Buyers And Sellers
I've worked at top Bay Area law firms and have extensive experience with business entity formation, mergers, dissolutions, conversions, employment matters, including experience in reviewing and negotiating transactional documents such as leases and purchase agreements.
|Janet Carrera - Escrow & Bulk Sale Services - SF Bay Area
Redwood Escrow Services, Inc. is a full service, licensed independent escrow company. We are EAFC Fidelity bonded, fully insured & licensed with the Department of Corporations. Committed to offering our clients the most comprehensive variety of escrow services available. Phone Janet at 510-247-0741.
|Mike Brewer: Liquor License Brokers, ABC Consulting Services
Liquor license brokerage and consulting services. We provide: Alcohol License Transfers Application Consulting & Processing, Liquor License Purchases & Sales, City Zoning Permits & Land Use Entitlements, Public Convenience or Necessity Findings and Letters. Phone Mike Brewer direct at 800-437-1100.
|Jeff Back, Broker: Restaurant Specialist - SF Bay Area
J. Back & Associates Restaurant Real Estate was founded in 1988 as the first bay area real estate company to specialize exclusively in restaurant real estate. I am the past President of Charley Browns restaurants and have been involved in the restaurant business for over 35 years. 925-736-8200.
|Related Articles, Events, Blog Posts, Discussions, Videos, Interviews|
|Is Starting With A Higher Selling Price A Good Strategy? The Pros Debate
Is it a good idea to start with a higher sales price for your business when going to market? San Francisco Bay Area Business Broker Rob Hartman initiates this Discussion on BizBen with other Advisors And Intermediaries on BizBen discussing this basic strategy of selling a small business in CA.
|How Do I Determine the Value Of My Small Business? Or The One I Want To Buy?
How do you determine the value of your business when you go to sell or even buy a business? There are so many factors and that is usually one of the first items serious buyers inquire about. Tim Cunha JD (SF Business Broker at 650-600-3751) initiates this Discussion On BizBen with other Advisors.
|Buying A Business: Why Is It Important To Look At Its Tax Filings?
Business tax filings are very important factor in determining the credibility of business financials. Just seeing those financials, you can't determine whether those values are overstated or not. Some business owners provide made up financials to buyers - so, that's where tax fillings come in.
|Who Really Represents The Business Buyer In A Deal? Does Dual Agency Work?
Who really represents the buyer? The selling broker or agent through dual agency? Many brokers and agents weigh in on this Discussion on BizBen. Bottom line is all business buyers need to know who really represents them and has their best interest at heart when seeking and negotiating on deals.
|Preparing Your Bay Area Business For Sale: Accounting & Financial Statements
The first thing you should start working on when selling your business is getting your financial statements in order. Having correct, easy to read, simple financial statements Is key in showing interested buyers. Rob Hartman (SF Bay Area Business Broker) shares his experience.
|An Alternative Approach To Finding And Buying An Absentee Run Small Business
As a SF Bay Area business broker (Rob Hartman), the phrase I hear often from my buyer clients is, "I am looking for an absentee run business." Since it is such a popular topic, let me offer an alternative method of business selection. There are a couple things to keep in mind as you search.
|Getting An SBA Loan To Buy A Small Business: Dispelling Some Major Myths
When seeking SBA loan financing many potential business buyers have wrong information about the process of securing the best financing to buy a business. Peter Siegel, MBA (at 866-270-6278) a business purchase financing expert delves into the myths and facts regarding SBA loan financing.
|BizBen Index: Weekly Results - 274 California Businesses Sold 5/21 - 5/25
For the week of 5/21 thru 5/25, 274 California small businesses were sold by business owners, business brokers, and agents. In 2017 16,956 CA small businesses were sold. So far this year (2018) 3,896 small to mid-sized California businesses have sold so far by business owners, agents, and brokers.
|See All News, Tips And Events|