When investigating a business for sale that involves inventory, there is often confusion regarding how it should be treated in the overall valuation.
In some industries, it is common for the inventory to be carved out so that the asking price is x amount plus inventory. This happens more frequently in the retail sector, but it is not limited to those alone.
Part of the problem goes back to how things have “always been done” although this rationale does not hold any weight in my opinion because it does not necessarily mean it has ever been the right way.
However, that thinking can present challenges to prospective business buyers because the business for sale market is steeped in legacy.
From a buyer’s perspective, inventory may be the single most important asset they are acquiring and so one cannot just set is aside and accept what is being presented.
Rather, a buyer must thoroughly analyze the inventory from two aspects: First, is it good and resalable? Second, does the inclusion of it make sense with the overall valuation?
On the former point, a buyer will want to analyze whether or not the inventory they will be purchasing can be turned into revenue in a reasonable period of time.
Obviously, this is a much easier task to undertake in perishable items, but less so when we are talking about nuts and bolts for example. Using a company’s sales by item data over the past year will provide you with an indication of what you can realistically expect to convert to sales under normal conditions after you take over.
Regardless of how current the inventory may be, it is always worthwhile to try to negotiate terms on it. This can include paying for it as it sells, having the seller finance part or all, or, getting an overall discount on the complete package. For any items that cannot be readily sold then of course you will want these discounted. However, if the potentially obsolete or slower moving items represent a small percentage of the entire inventory, sometimes it is not worth the fight.
As it relates to the second point of valuations, there are a few things to consider. The seller has to turn over the business to a buyer with an optimal level of inventory to sustain the revenues. If not, then the valuation itself has to be modified. After all, a proper asking price reflects normalized activity in the business and so if they are not including inventory that will ensure the continuation of that activity, the valuation must be adjusted.
Just like a business where there are tangible assets like machinery and equipment which are included in the purchase, the same holds true for inventory.
Hard assets are a means to drive revenue and surely a seller cannot expect top dollar based upon a multiple of Owner Benefits and then get a premium for the equipment over and above.
Again, the key here is to realize that this very equipment (or inventory) is what is needed to produce the products that will be sold to clients to generate the profit upon which the business is valued. If a buyer has to take over and immediately replenish the inventory, they must certainly factor in this additional working capital requirement and the impact on near-term sales potential.
While a seller may remain rigid in wanting to have the inventory as an “over and above” item, the buyer must ensure that when all of the components of the valuation are added together, the total purchase price makes sense as a whole.
Over the next five weeks I will be doing a webinar series sponsored by Guidant Financial Group covering: Buying a Business in The Current Market, Finding the Right Small Business, How to Accurately Value a Small Business, Small Business Financing Options, and Due Diligence When Buying a Business. If you would like to learn more click here:
Have a great week!