Handling Inventory When Selling a Business
Knowing the proper way to handle inventory when selling a business is an important part of business brokering and those untrained in the profession generally have no idea what to do. This issue arose recently when a business owner hired a real estate agent to sell her business.
As many of you long-time readers know, I’m not fond of realtors selling businesses. It’s like mechanics selling houses or podiatrists replacing your brakes. It generally doesn’t work out too well because unless they’re working in the field for which they’ve been trained, the realtor, the mechanic and the podiatrist don’t know what the heck they’re doing.
But let me state here that many of my subscribers are realtors trying to get educated on this marginally related but potentially much more lucrative profession of business brokering. (I mean, how many million-dollar houses do you list every year, eh?) I admire you guys and gals because you’re trying to learn how to do this the right way.
But if realtors – or anyone else, for that matter – needed an argument for learning how to sell businesses, the following tale of woe is a strong one.
The subject business is a decades-old landmark for travelers and a favorite of locals as well. Serving “down-home” meals at reasonable prices, offering local produce and crafts, hunting and fishing supplies, and adding petrol about 25 years ago, it has been serving truckers, travelers and three generations of many families since the 1940s. I pass it once or twice every month as I travel between two of our offices and it is almost always busy, no matter the time of year. The business owner wants to sell.
But what does the owner have to sell? How will the structuring of the sale impact her net, particularly is it pertains to taxes? And how should the opportunity be marketed with regard to price?
The owner – who, I hasten to add, I don’t know – has a reputation for pinching pennies. But the expression “penny wise but pound foolish” is appropriate in this case because even though she had a $2 million (revenue) business, she consulted no one – such as a tax attorney, an accountant or a business broker – who might reasonably have been able to help her structure the transaction to her best advantage. Instead, she consulted a residential real estate agent and someone at the company that handles that agent’s closings, neither of whom had the slightest experience with selling businesses.
What Was On Offer?
In this case, there were several “items of value” that comprised the sale.
- The real estate, which is presumably why the owner called a real estate agent.
- The business’ tangible and intangible assets, which included its name, phone number, website and sundry similar assets
- The inventory
- The “goodwill”
Only two of these fours items was purported to have been valued: the real estate and the inventory. Unfortunately, both were valued by the owner!
The real estate agent – a residential agent, at that – didn’t know how to value a commercial property and, thus, agreed to list everything except the inventory at the price the owner wanted.
The agent also took the owner’s word that the inventory was valued at $100,000. The listing – a real estate listing on a real estate multiple listing service – stated that the real estate was for sale for $750,000 and that the inventory could be bought for $100,000.
What’s Worth What?
We were not involved in this transaction (thank goodness!). As such I have no idea what the real estate was worth. But the allocation of assets, a crucial step in the structuring of the transaction to keep the seller’s current tax liability manageable and the buyer’s future tax position knowable, was completed ignored.
On top of that, unless the four components of the sale are broken out, the seller’s closing costs and the buyer’s future property tax liabilities could be higher than necessary.
But the big issue in this transaction was how the inventory was treated – which is to say, poorly.
What’s The Inventory Worth?
Inventory changes day-to-day in nearly every business. In many retail businesses, inventory spikes during the month before Christmas – but then plummets a month later. To say that the inventory “…can be bought for $100,000…” ignores completely the likelihood that the value of the inventory on any given day – let alone on the day of closing – will, in fact, be nowhere near $100,000.
So, how do we handle inventory?
We ask the seller to estimate the average value of the inventory on a day-to-day basis recognizing that it could fluctuate wildly. We explain the we’ll market the business at X price and that that price “includes inventory valued at (whatever the seller estimated)”.
You might think at this point that a seller could assume that she could pad the inventory a little bit – give it an extra $150,000 in value, say. (Yes, there are dishonest sellers out there as this post and this one will clearly demonstrate.) But we explain that an inventory will be taken the day before closing and the price will be adjusted – up or down – based on the value of the actual inventory at the time of the sale.
For example, we are working with a wholesaler/distributor that buys seasonal product in bulk, breaks that product down, repackages retail amounts of the product and distributes the repackaged products to hundreds of retail outlets in the U.S. and Canada. In season, the inventory level is about $450,000. Off season, it’s less than $100,000. We’re marketing the business at X price and “that price includes $250,000” in inventory.
If the business is sold at the height of the season, the price will be increased – possibly by something close to $200,000 – to account for the surge in inventory. Similarly, if the transaction closes in the off-season, the price will be reduced to reflect the actual inventory on hand at the date of closing.
This process dissuades dishonest sellers from padding their estimate of inventory value because they realize that the price adjustment will occur and they’ll get no benefit from lying to us (or to the buyer).
Our course, The Basic “How-To” of Becoming a Business Broker”, teaches how to become a professional business broker including how to value businesses and handle inventory.
Become a Professional Business Broker…
The Bottom Line
Having an inventory done by a disinterested third party eliminates much of the potential for the parties disagreeing on the value of the inventory. It will also help both parties when it comes time to report the transaction to the taxing authorities.
There are firms out there that do nothing but take inventory for businesses, large and small. We use them whenever inventory is involved in a transaction. Because having an accurate inventory at the closing is in the best interests of both buyer and seller, we are usually able to convince both that they should share the relatively small cost.
If you have any questions, comments or feedback on this topic – or any topic related to business – I want to hear from you. Put them in the Comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!
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