Inventory Valuation: Tricks and Traps!

by Toby Tatum
from: BusinessBookPress

Buying or selling a small business, if done in a way that minimizes the potential for purchase negotiations to fall apart or for post-transaction animosity—or possibly even litigation—between the buyer and the seller, can be a complicated process. As a business broker and as a former business owner who has bought and sold several restaurants, I have experienced first hand dozens of tricks, traps and unpleasant surprises that lie waiting to snare unsuspecting buyers and sellers. I addressed all of these things in my book, Making a Small Business Purchase Offer: Everything You need to Know to Successfully Close a Deal! .

There is one incident that I'll tell you about here that I encountered as a business broker assisting a client with selling his discount liquor/convenience store. It had to do with the amount the buyer would pay for the seller's inventory.

In this case, which is typical, the purchase offer indicated the amount the buyer would pay for the inventory on hand at close of escrow. The offer stated that the buyer would purchase the inventory at the seller's cost and included the caveat that the price stated in the purchase offer was only an estimate; that the exact value of the inventory would be determined via a physical count to be taken immediately preceding close of escrow.

As agreed between the parties, in the early morning hours on the day escrow was to close, the seller had an inventory counting service come into his store, count every product on the shelves and note the retail price of each item. The seller therewith came to the closing meeting with an exact representation of the value of his inventory at retail. And here is where the transaction process fell apart.

During the course of purchase negotiations, the seller told the buyer that, on average, his merchandise's retail price was 30% above his wholesale cost. So, with a letter from the inventory counting service stating that the value of the seller's inventory at retail prices was determined to be $130,000, the buyer agreed to pay 70% of that amount, or $91,000. The seller said that was not enough, an argument ensued and the buyer, together with the business broker assisting him, walked out of the meeting. The deal had fallen apart at the very last stage in the process.

Fortunately for me at least, since I wasn't going to get paid unless the deal closed, the buyer and seller got back together later that day and consummated the transaction. The buyer agreed to pay the seller $100,000 for his inventory instead of the $91,000 he previously insisted was the correct amount.

So, whose calculation of the seller's cost for the inventory was right, the buyer's or the seller's? I'll give you a hint: I was representing the seller. Since the seller's merchandise was marked up 30% (on average) above its wholesale cost, then the cost of goods sold reflected on his Profit & Loss statement was 76.9%. For example, if an item cost $1.00 and is sold for $1.30, the cost of goods sold expressed as a percent of the selling price is $1.00 divided by $1.30 which equals 76.9%. Therefore, once the retail value of the inventory was determined to be $130,000, the correct way to calculate its wholesale cost was to multiply that amount by the seller's cost of goods sold of .769 as reflected on his P&L. $130,000 times .76923 = $100,000.

In the example I just cited, determining the wholesale cost of a business owner's inventory given its retail price is simple. However, not all value determinations are this simple. In some cases it may be best to separate merchandise by the categories appearing on the profit and loss statement and calculate the wholesale cost of each category using the method described above. In other cases, the best way is to match each item of inventory with the vendor's invoice—it all depends on the unique circumstances of a particular business, what's reasonable and practical and what the buyer and seller can agree upon. I recommend that the buyer state the valuation methodology for the inventory in the offer itself. Doing so should avoid the kind of unfortunate incident I have related here.

A few days later the buyer asked me to meet him at the store he had just purchased. He said he wanted to show me something. When I met him at his new business he showed me several items on the shelves. Although he had no proof, he said it appeared that the seller had gone through his entire stock of merchandise the night before the escrow closing day and placed new retail price stickers on everything—at higher prices than his standard 30% mark-up!

Be careful, it's a jungle out there!

About the Author

Mr. Tatum is a member of the International Business Brokers Association, (from which he has earned the designation Certified Business Intermediary), The M & A Source, the world's largest networking organization of Business Transaction Intermediaries specializing in the sale of midsize private companies, the Institute of Business Appraisers and the Institute of Certified Business Counselors from which he has earned the designation Certified Business Counselor.

Mr. Tatum is the author of two books, Making a Small Business Purchase Offer and Transaction Patterns .