When I help clients negotiate a Letter of Intent (LOI), often we will show a base price of the business plus the inventory at wholesale cost, with the combination of the two being the total price of the business. The inventory is an asset of the business that's necessary for its operation. Buyers expect that a business will come with inventory consistent with what's been carried in the past so that there is continuity of the business when the transaction closes.
The only reason that we delineate the inventory in the LOI and Purchase Agreement is to prevent perceptions of game playing and disagreements between a Buyer and Seller about inventory levels at closing. In other words, had we said that the price was $1,750,000 for the business (without breaking out the inventory, which at time of LOI was $500k) then when closing rolled around if the actual inventory ended up being $600k, a seller would be inclined to say "wait a second - when we signed the LOI the inventory level was only $500k, now it's $600k, Mr. Buyer you need to pay me an extra $100k for the business - I'm not going to sell for $1.75 million." In contrast, if at closing inventory was only $400k a buyer would be inclined to say, "Mr. Seller, I wonder if you've intentionally depleted your inventory. You should have been replacing the inventory you consumed to keep it consistent with the levels that were present when we signed the LOI. We need to amend our agreement to decrease the price by $100k." However, by saying the price is $1.25 million plus inventory it results in a total price that naturally adjusts.
Of course, there are other ways this could also be addressed in the language of the documents, for example, saying that $500k of inventory would be included and that if it was more or less at time of closing the overall price would simply adjust. Regardless of how it is addressed, most buyers expect to acquire inventory needed to operate the business and will want the overall closing price to be adjusted to reflect any changes in the level of inventory that occurred from the time the LOI was signed until closing.
Some sellers may say, "OK - but if we are showing inventory as an additional deal component but only at our cost - that shouldn't be subject to the commission we didn't make a profit on it." However, the base price of the transaction is where the intangible business value is captured, and a buyer will need sufficient inventory to operate the business. If a seller said, I'm just going to sell the inventory on my own and the buyer can acquire their own inventory there would be a number of issues:
- The seller would still need to find someone to buy their inventory at closing and a third party willing to buy it would likely pay a discount for the inventory compared to if buying it directly from a supplier. There also may be advertising or selling costs to locate a buyer and negotiate a sale of the inventory.
- A seller will have a difficult time managing their inventory down to a minimal level to coincide with the business sale transaction closing.
- Many businesses have a variety of types of inventory and some of it must be bought in minimum quantities - so requiring a buyer to obtain these minimum quantities directly from suppliers may be less economical than the buyer simply buying a seller's inventory.
- A buyer will need to have all inventory on hand at closing to avoid an interruption of service to clients, and if they wait until closing to buy their own inventory there may be a gap in service and corresponding decline in the business.
- Buyers expect that they will be acquiring sufficient levels of inventory to maintain the operation of the business. Consequently, they will be annoyed if they have to jump through hoops at or before closing to take care of stocking raw goods inventory.
- Depending on the type of business there might be a long lead time in the manufacturing process to take inventory from raw goods inventory to a finished product. If that is the case and there aren't work-in-process or finished goods inventory included with the assets a business buyer will have a delay between the acquisition of the business and creating the finished goods inventory that can be sold to customers.
About the only time that inventory may not be included in a sale, or where a commission might be negotiable (which should be negotiated at time the listing agreement is signed) is if there is significant excess but marketable inventory beyond what is required for the normal operation of the business.