Guide to Inventory Issues When Buying Or Selling A Small Business - 7 Key Items

Have you ever counted 3,546 small plastic insects?

I have.

One of my first sales as a business broker years ago, involved a party store that was sold to a young couple by the long-time owner who wanted to retire. And since the deal called for the buyers to purchase the inventory at cost, it was necessary to count each and every item in stock--whether on display in the retail area at the front of the store, or in backroom storage. Somehow, it fell to me to count the little items formed out of plastic to look like spiders and ugly bugs--the kind that people might purchase to frighten their friends as a joke.  What was frightening to me about it, was reaching the count of 3,437, wondering if I’d missed counting one of the green beetles, and thinking I might have to start over.

Not every buyer and seller feel it’s necessary to be quite that exacting, fortunately, but the story illustrates that the process of taking inventory during due-diligence is a serious matter to principals in the sale of a small business, and is, in fact, a critical part of completing the transaction successfully.
Here are some things you need to know, whether you are a buyer or a seller, about the inventory count that is conducted in connection with the sale of a small business, so you can complete this process successfully.

1. Part of the dollar value of the deal

In a transaction that calls for the goods that are held for resale to be priced and purchased in addition to the other assets of the business, the final count is a necessary part of closing the escrow. If the sales agreement pertaining to--as an example, a gift store or an auto parts company--specifies a dollar value for the stationery property (such as furniture and fixtures) and equipment, along with goodwill and other intangible assets, there invariably is a second and related part of the transaction by which the buyer purchases the inventory that will be needed to conduct the business.  An alternate approach is the deal in which the inventory is considered to be part of the purchase price of the business, not subject to an extra purchase. And frequently, to avoid disagreement over what is, and is not a fair part of the sale, buyer and seller will reach an accord about the anticipated value of the inventory when the deal is about to close. Without a solid agreement as to closing inventory value, the buyer may worry that there will be little or no inventory included, which means that he or she will have to shell out more cash than expected in order to open the doors. Meanwhile, the seller’s concern can be that a buyer’s expectations will be unrealistic, thinking the “included” inventory will be sufficient for six months’ worth of operations, while the seller had a lesser amount in mind. It’s for this reason that the principals are advised to reach agreement not only about the idea that inventory will be included in the price, but also, about the value of that inventory. The final count, if it shows more inventory than anticipated, would result in a slightly higher closing sale price--higher by the amount that actual inventory exceeds the value anticipated. And a lower price might result by the amount that an actual valuation is less than the agreed-on inventory amount.  In either event, the count is critical to completing the deal.

2. Accuracy is important

And a general “guestimate” won’t do, as the buyer’s accountant is most likely going to insist on an exact figure, when setting up the books of the business, under its new ownership. For the buyer to determine how he, or she is doing in the first few months, it will be necessary to have accurate gross profit figures and, that translates to net earnings performance. It is difficult to make those calculations, however, without knowing the cost basis of starting inventory.

3. Physical count is needed

Actually counting the inventory is recommended, despite the assurance of some sellers that the “book” value of the inventory is accurate because of the inventory control software used in the business. Indeed, this technology is very useful. It maintains a count of inventory in its digital memory, and that inventory value can automatically be increased by the amount of the new goods brought in by suppliers--and logged into the computerized count, and decreased every time the scanner at the customer check-out station registers and item being sold-and in what quantity, so an appropriate deduction can be made in the computer. The problem is that the computer count doesn’t always correspond to reality.

4. Count everything

It is not just stock held for resale that needs to be counted and valued. Service companies which use materials and supplies, even restaurants that use quantities of eggs, hamburger patties and cola drinks, should be subject to a physical inventory prior to close of escrow. The buyer who recently took over an exterminating company was surprised to learn the high cost of the “environmentally neutral” chemicals used in the business. He’d asked the seller to “throw in” the inventory of supplies but the seller rejected that idea, noting that “it would be like ‘throwing in’ one of the company’s vehicles for free.”

5. Informal training opportunity

If buyer and seller have a good relationship, it is recommended that they conduct, together, at least part of the inventory count. That’s because a review--and the ensuing discussions-- of the products being sold by, or used in the business, provide an opportunity for the buyer to begin getting educated about the business.

6. Splitting the difference

“Split the difference” is a handy phrase and a very useful concept to employ when conducting inventory. What should the buyer pay--actual cost or half-cost--for a product being counted which cannot be sold at full price, but still has a value to some customer? Split the difference.

7. Inventory services available

Buyers and sellers are encouraged to bring in an inventory service company if there is so much product that the principals don’t want to take the time and energy to count it.  Charging from about $150 to $300 per hour, inventory services can make pretty fast work of what looks like a daunting challenge. The service will count the items in each category, determine the cost from the vendor catalogues or cost sheets, and then perform the computations to arrive at the value of the inventory at cost. Use of an outside inventory firm might also be a good idea if there is discord between buyer and seller. Many brokers have experienced a situation or two in which the parties are committed to close the escrow, but have come to dislike, or distrust one another in the course of the transaction. Savvy brokers know that to put these principals together for an afternoon in the stock room, engaged in the tedious--and possibly contentious--process of counting widgets, may be to invite trouble. So it might be a good idea to hire an independent service. In fact, that may be why the job of conducting inventory is sometimes taken on by one of the brokers in the deal.

A broker can be so eager to close a sale that he will be willing to count little plastic insects--all 3,546 of them.