Inventory Valuation in the Sale of a Business

Feb 27, 2018

Effective inventory management in 2018 requires the ability to balance timely delivery of product to customers with Just-in-Time (JIT) inventory management strategies designed to increase efficiency and decrease waste by taking advantage of current technology and logistic opportunities.   Customer satisfaction is documented for entrepreneurs in “real time” with online reviews & repeat orders.   Failure to deliver advertised product on time can result in back charges and loss of sales in business to consumer sales venues like Amazon or a failure to secure future orders from companies like Boeing in business to business sales environments.

This 21st century dynamic environment emphasizing intelligent deployment of capital assets has dramatically improved the quality of the inventory included as a tangible asset in the sale of privately held companies in the manufacturing, distribution, and retail sectors.

The most sophisticated inventory valuation in the sale of a business occurs in transactions involving manufacturing companies.   The process involved in properly valuing the inventory of a manufacturing company requires experience, knowledge, and the ability to facilitate discussion & negotiations between parties related to the cost and return on investment potential of products in various stages of completion from raw materials to finished products ready for shipment.  The valuation of each component should incorporate materials, labor, overhead, and liquidity.

An interesting case example for conceptualizing the sophisticated nature of the value of inventory in a manufacturing context is a winery in autumn.  A winery at this time of year will have grapes on the vine awaiting harvest, raw materials at the winery (grapes & bottles), juice in tanks, wine in barrels, and wine in bottles.   The value of the grapes on the vine will incorporate factors ranging from the reputation of the AVA (American Viticultural Area) to the scarcity & quality of the varietal to the percentage of the crop that has a probability of being harvested.  The value of the harvested grapes will incorporate a load for labor & overhead over the value of crop on the vine.  Supplies such as bottles, corks, barrels, etc. are valued at cost, with an appropriate load for transportation costs associated with delivery of the product to the winery.    The value of juice in tanks will include a load for labor & overhead above the cost of the raw materials.  The value of the wine in barrels will have a higher value than the juice fermenting in tanks because it is closer to sale to a customer than the wine in tanks.  Arguments can be made for including barrels in furniture, fixtures, and equipment or inventory.    The value of a barrel, a depreciating asset for a winery, starts with its cost and depreciates to the market value achievable when sold for a secondary use (e.g., planter box).  The value of the wine in bottles should incorporate the venue employed to sell the product.   Small production wineries selling direct to consumers will justify a higher transactional value for their bottled wine than wineries selling product through distributors or to large format retailers.  The governing concept when valuing inventory is can the purchaser make a reasonable profit when the inventory is sold given their acquisition cost, carrying expenses, and the liquidity of the product.  A degree of speculative risk exists in the acquisition of wine as the quality of a year or product will not be known until it is assessed by the public and parties that influence opinion.

The principles associated with valuing inventory and work in process at a manufacturing company for transactional purposes are the same whether the product being discussed is wine, machined parts, or fabricated items.   It is recommended that the parties employ a knowledgeable party to facilitate discussion & negotiations related to inventory value.  It is in the best interest of both parties to have an organized inventory valuation process occur in an environment of full disclosure.  It is a reasonable expectation of the seller that they will receive a “fair market” value for the inventory.   It is a reasonable expectation of the buyer that they will not be asked to purchase damaged or obsolete inventory that will either need to be disposed of or sold at a discount below the acquisition price.  All inventory purchased by the buyer should have the ability to be turned into cash including a reasonable profit margin.

The process involved with valuing inventory at a retail or distribution business for transactional purposes is substantially similar to the valuation of inventory at a manufacturing company with the exception that there is generally not any work in process.  Similar to the manufacturing example, loads should be applied to values for transportation costs when appropriate and an effort should be made to identify any damaged, obsolete, or slow-moving inventory.   It is always our recommendation to clients that they attempt to sell this questionable inventory prior to the sale being completed to mitigate the potential for confrontation in valuing & assessing inventory.  An orderly liquidation of this inventory is also in the financial “best interest” of the seller as the value they are likely to receive is generally greater than the value a business buyer will pay for the inventory, even if the value is only 10% above their cost, a deeply discounted value in a business to consumer transaction.  In a retail environment, especially during the summer & autumn, it is common for businesses to receive inventory from their suppliers with favorable payment terms (e.g., delivery in August with payment due in January).  If this is the case, it is common for business buyers to assume financial responsibility for the inventory, but not pay for it at closing to take advantage of the terms offered to the business as an entrepreneur.

The final valuation of inventory occurs in close proximity to the closing date for the transaction.  It is recommended in a professionally facilitated transaction to have a preliminary inventory value established and recognized by the parties early in the sale process. This two step inventory process will mitigate confrontation, assist with acquisition budgeting, and allow for the identification of damaged, obsolete, or slow-moving items that need to be removed from inventory while the seller still owns the business and can use that vehicle to sell the merchandise.

The successful negotiation of the sale of a privately held company or family business is a sophisticated process requiring knowledge, experience, and a strong professional skill set.   If you own a business and are interested in learning about the professional process employed by IBA to sell over 4000 privately held companies and family businesses for clients from Anchorage to Phoenix and from Seattle to Chapel Hill we would welcome the opportunity to talk with you.

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, and mergers & acquisitions community on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.