It is not unusual for businesses that have been in business for a long time and have been doing well financially, to have much more inventory than is necessary for their type of business. Since most businesses have some inventory, I’m primarily referring to distributors or retailers whose primary asset is their inventory. This isn’t a problem for the business owner until they want to sell their business.
When we give a business owner an estimate of the selling price of their business, we use databases of business sale information to calculate the estimated selling price. One of the most popular databases, Bizcomps, gives us figures that do not include inventory. When using these comps, we must add the actual value of the inventory of the seller’s business to get an estimated selling price with inventory. When there is too much inventory, we can end up with a selling price that won’t be acceptable to a buyer or a lender. Let me give an example.
Let’s assume we are selling a hardware store with $1,000,000 in sales, $400,000 in inventory, and $150,000 in Seller’s Discretionary Earnings(SDE). An average gross profit for this business is about 38% of revenues so cost of goods sold would be $620,000. Average inventory turnover is about 2.7 so the average inventory would be $230,000. This is how much a buyer should need to operate this store. Let’s assume the market selling price is 1.8X SDE plus inventory. Using these figures in this example would give us a selling price of $670,000 (1.8X 150,000 plus 400,000). Let’s assume an SBA loan with 25% down and the balance paid over 10 years at 6% interest (a common lending scenario today). The buyer would be borrowing $502,500; let’s assume the buyer needs $80,000 a year to live on. The loan payments would be about $67,000 per year. This situation would not be acceptable to a lender or a buyer. Typically, 1/3 of the cash flow is the maximum a buyer would be willing to pay to service their debt. In this situation, that would be $50,000. For a lender, after deducting the $80,000 a buyer needs to live on, they would be left with $70,000 to service the debt. Lenders look for a much higher coverage ratio, 25% to 35%, than the 4% in this situation.
What this analysis shows is that you can’t just add the extra inventory to the selling price and expect a buyer to pay for it. If we did so, we would be advertising this business for over 4X SDE, a high figure and higher than alternative businesses a buyer can buy. Also, a buyer recognizes there is too much inventory and simply doesn’t want to tie up their money in it.
Here is how to sell a business with too much inventory. What we need to do is offer the business for sale with the proper amount of inventory and dispose of the extra. Since it normally takes several months to sell a business, the seller can be doing this while the business is being marketed by the business broker. If some of the inventory is obsolete or not salable, a buyer would not accept it so it’s best just to get rid of it in the best way possible. The rest, which is, presumably, good inventory but more than needed for a good inventory level, can be reduced over time by the normal sales of the business or making returns to vendors.
If the inventory hasn’t been reduced to the agreed upon level by the closing date of the sale, there are still ways for the buyer and seller to deal with it. The seller may sell the inventory to the buyer. The seller may give the buyer extended terms and/or a discount to give the buyer an incentive to buy the inventory. Another alternative is for the seller to sell the inventory to another company.
There are many ways to deal with excessive inventory when selling a business, but simply expecting the buyer to buy it, is not the best way to do so.