Smith Holland M&A Resources
Factoring inventory into the deal structure.
Inventory is a common asset both sellers and buyers need to pay close attention to during a transaction. While not every company has inventory, for those that do, it can be a high-value line item that is as much a necessity as the processes and people running the show.
Much like employees and financing strength of the company, inventory generates cash flow imperative for the success of the enterprise. Unlike other assets, such as machinery and equipment, the turnover rate of inventory can be constant, even multiple-times a day -- think everyone’s favorite jungle-named online retailer.
For these reasons and more, it is imperative to have an accurate accounting of inventory on hand, as well as inventory on order when you are preparing to sell your business. The value of inventory directly factors into the valuation during the acquisition process and it's important to work with an experienced mergers and acquisitions firm that can help you structure the deal accordingly.
At a macro-level, determining the cost of inventory during an M&A deal has many levers. Below are the most relevant factors both a buyer and seller need to keep top-of-mind during the transaction process.
Auditing Inventory. It is very common to kick off the selling process with a current accounting of inventory. As the sale progresses, it is normal for the company to continue full operations as the change of guard occurs. During due diligence, another accounting of inventory takes place, and if it is in an acceptable delta range from the initial offering estimate, both parties should move forward with the sale. If there is a large discrepancy, over or under, one solution is to agree on a final inventory valuation to be included as part of the sale, with that inventory being in stock on a predetermined date. For example, both parties can agree that when the closing occurs in 30 days, Johnny’s Apple Stand will have 20 green apple, 10 red apples, and 50 baskets on hand. That way, when the closing date arrives, the seller can’t burden the buyer with a surprise inventory number and jeopardize the transaction.
Variability of Inventory Johnny’s Apple Stand faces a common problem, the quality of inventory. Some might be broken, some might have aged, some might just not be in style or in market favor. All of these factors need to be considered when purchasing the inventory assets of a company. No one wants to buy a rotten apple, and then have to try and sell it!
Valuation at Cost. Elaborating on that last example, imagine the inventory assets are way higher than are needed during typical business operations. Perhaps people aren’t buying apples due to the weather, so Johnny’s Apple Stand has triple the amount of apples on hand at the time of the sale. One way to remedy is to have the seller agree to include the excess apples at a discount. This incentivizes the buyer to earn extra margins once those apples are sold.
Inventory Valuation. The ultimate solution is a third-party valuation firm when it comes to inventory. They will have a non-biased, market-focused approach to determining the cost of these assets. Of course, it is preferable for the buyer and seller to handle this matter internally, either agreeing to fair market value, or one-to-one cost that the seller incurred. It is rare for the buyer to pay more than the inventory cost the seller, especially if the seller is an affluent business person that understands each piece of the process to value his/her product before it hits the shelves.
Manufacturing Inventory. The last factor in inventory valuation deserves a section of its own, as seen below. The first step in manufacturing inventory valuation is to determine the state of assets, where Raw Materials, Goods in Progress, or Completed Goods. For Johnny’s Apple Stand, Raw Materials would be apple seeds or wood to make baskets. The Goods In Progress would include apples growing on trees as well as baskets being woven by hard-working employees. Lastly, Completed Goods would be, you guessed it, completed baskets full of apples to eat!
As opposed to drop-shipping or consignment retailing, the manufacturer mindset of inventory requires special focus:
Completed Goods. A parallel to retail inventory, finished or completed goods valuation should include labor, equipment, overhead, and any other fixed costs associated with bringing the asset to market. This line item is essential to understanding the velocity of the business, as it represents both the endpoint of the manufacturing process and the start of the marketing and sales pipeline.
In Progress. When categorizing work in progress, one must take into consideration the value of the processes the asset is going through. Labor, utilities, and other fixed costs are all calculated as part of the manufacturing process, so any assets, under those circumstances, should be given a higher valuation than the raw materials (see below). That exact value, however, must be narrowed based on the stage of the manufacturing process as well as costs sunk into the assets at the time of the enterprise being sold.
Raw Materials. The raw materials category covers anything in the pre-production process. It hasn’t been refined, modified, or put into a pipeline for sale. Typically, these assets are translated on a one-to-one valuation. What the current owner paid is what the potential buyer should feel comfortable paying. The current owner might have even been able to obtain a discount on the raw materials due to good standing with a supplier or financier, which bodes even better for the potential buyer and the transaction in general.
By now it should be clear the keystone inventory places is evaluating a company during the due diligence process. Understanding where the assets are held throughout the ordering, manufacturing, and selling pipelines are crucial to ensure both the buyer and seller are confident on the value being presented. The return on investment from properly assessed inventory can sweeten a deal or sour a potential closing. If you had two apples in a basket, and someone wanted to buy your basket, wouldn’t it be nice to know if you should keep the apples or include them in your deal -- but be sure to check if they’re rotten first -- not all inventory is equal!
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