Have you ever counted 3,546 small plastic insects?
One of my first sales as a business broker intermediary was a party store sold to a young couple by the retiring owner. Because the deal called for the buyers to purchase the inventory at cost, it was necessary to count every item in stock, whether in the retail area or in storage. Somehow, it fell to me to count the little plastic bugs—the kind that people use to frighten friends as a joke. What was frightening to me about it, was reaching the count of 3,437, wondering if I had not counted one of the green beetles, and thinking I might have to start over.
Fortunately, not every business buyer and seller are quite that exacting, but the story illustrates that the process of taking inventory 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 for a small business sale, so you can complete this process successfully.
1. Part of the dollar value of the deal
In transactions that call for the held goods to be priced and purchased as part of the assets of the business, the final count is a necessary part of closing the escrow. If the sales agreement specifies a dollar value for the stationary property (such as furniture and fixtures), equipment and intangible assets, then there is invariably a second part of the transaction by which the buyer purchases the inventory that will be needed to conduct the business.
To avoid disagreement over what is and is not a fair part of the sale, buyers and sellers will often 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 may worry that a buyer’s expectations are unrealistic, thinking the “included” inventory will be sufficient for six months’ worth of operations, while the seller had a lesser amount in mind.
For these reasons, 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. After the final count, if there is more inventory or less inventory than was estimated, the closing price will be adjusted accordingly. In either event, the count is critical to completing a fair deal.
2. Accuracy is important
A general “guestimate” won’t do, as the buyer’s accountant will likely insist on an exact figure when setting up the books of the business. For the buyer to determine the net earnings performance of the business in the first few months, it is necessary to have accurate gross profit figures. It is difficult to make such calculations without knowing the cost basis of the 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 and can give an accurate estimate, but the computer count doesn’t always reflect the reality. Input errors, software glitches and shoplifting are some of the reasons that a store manager, looking at the computer, will insist there is a certain item in the store, though a physical search verifies that the product has somehow “disappeared” from stock. The smart buyer should absolutely insist on a physical inventory before the deal is finalized.
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 had 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 the 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 or used in the business provides an opportunity for the buyer to become acquainted with the business. Questions that will occur to the buyer during training and subjects that the seller will want to explain at that time can be covered while the two are engaged in counting and checking the pricing of items in the inventory.
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.
How about an item that has been around for awhile—long enough that it’s current cost is higher than what the seller actually paid many months back, off an old price list, when it was added to inventory? Split the difference.
7. Inventory services available
Business 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. Inventory services charge about $150 to $300 per hour, but can make fast work of what seems a daunting challenge. The service will count the items in each category, determine the cost from the vendor catalogues or cost sheets, and then calculate the value of the inventory at cost. The parties might want to ask the escrow holder or a broker for a recommendation of a responsible service, or they can check online or in a business service directory.
Use of an outside inventory firm might also be a good idea if there is discord between the 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 inviting trouble. Hiring an independent service may be the best way to keep the peace, and the deal, intact.
The other option for brokers—do it yourself. 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.