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.
Contributor:
Cheryl's a restaurant business broker, over 25 years in the bar and restaurant industry coupled with a J.D. Cheryl works tirelessly to create successful strategies and effective negotiations for those who wish to purchase a new or sell an existing bar, restaurant, cafe, or night club. 415-309-2722
ServingCity Of San Francisco
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.
ServingSan Francisco Bay Area, North Bay, Central Valley
Laundry consulting, due diligence, buyer representation: We preview laundries for you and evaluate them. 28 years laundry industry experience: buying, selling, valuing, retooling, analyzing, consulting services for laundry buyers and entrepreneurs in California. Contact us today about our services.
ServingAll California
The Veld Group provides a refreshing approach to Business Brokerage, Mergers & Acquisitions and Business Consulting and Valuations. From Your Street to Wall Street, we cater to Main Street Businesses as well as more complex Strategic Firms and Start-Ups.
ServingSouthern California
If your business involves alcoholic beverage sales, we can help. Obtaining a liquor license transfer or selling a business with a license in California does not have to be a frustrating and overwhelming process. We have procured thousands of licenses for our clients.
ServingAll Of California
Laundromats and coin operated Laundromats are popular choices among business buyers as they often can be successfully run as an absentee run business. You need to be strategic about when you sell your Laundromat so you don't get taken to the cleaners by a buyer and so that you maximize your profits.
Buying a professional service business, like a dental practice, is one of the most profitable ventures you can enter into if you are considering becoming a small business owner. In this blog, Peter Siegel, MBA discusses six things you need to know about buying a successful dental practice or office.
Chuck Post a laundry consultant, specialty broker, buyer representative & due diligence advisor starts this discussion on why it's important to have an exit strategy in mind while buying a laundromat! He & others explain why this concept is so important for buyers especially in the laundry business.
Buying a liquor store can present some major challenges to business buyers - a recent client on the BizBen ProBuy Program relates to Peter Siegel, MBA what the major challenges may be when searching for and buying a Californa liquor store business. I welcome other Advisors to weigh in on this topic.
Sometimes business brokers just can't win with their clients, because if an offer comes in too fast & too early then they must have lowballed the price & the seller is suspicious, and if not enough offers come in after putting the business on the market - they may look unproductive to their clients.