How Inventory Is Counted and Paid For at Closing

Inside the price or on top of it

There are two common ways to handle inventory in a sale. In the first, the purchase price includes a normal level of inventory, and the agreement says what normal is. If the count on closing day comes in below that level, the price comes down. If it comes in above, the buyer may pay more, or may not, depending on what was written. In the second, the price is for the business, and inventory is bought on top of it at the value counted on closing day.

Neither is better for every seller. A business with steady stock that barely moves from month to month is often fine with the first. A business where stock swings with the season, such as a garden center, a heating supplier or a retailer who stocks up before the holidays, usually does better with the second, because the amount sitting in the building on the closing date could be a lot higher or lower than the average. We would not want you to learn that a closing in the slow month cost you money you had no way to see coming.

Your letter of intent is where this gets set. Our post on letters of intent shows the places owners tend to leave a sentence out, and inventory is one of them. A line like "price includes inventory" is not enough. It needs to say at what value, counted how, and by whom.

Cost, not what it sells for

Inventory is valued at what you paid for it, or what it would cost to replace if that is lower. The shelf price does not come into it. An owner who sells goods at a healthy markup and expects to be paid the retail value of the stock has misunderstood how the buyer is looking at it, and the buyer will not budge. The buyer is buying the stock so they can sell it, and the markup is the profit they hope to make.

Cost should come from invoices, not memory. If you buy from a few suppliers, the invoices are easy to pull. If you buy from dozens and prices change, your accounting system or point of sale should be able to produce a cost report, and the buyer will want to test a sample of items against supplier invoices. It saves time when your system's cost figures match what you paid. A cost that has not been updated in years is something the buyer's accountant will find on the first afternoon.

Freight in, duties and handling can be part of cost in some agreements and left out in others. Decide before the count, in writing, because it is much harder to argue about on closing day with a pile of boxes between you.

What is left out

Buyers pay for stock they can sell at a normal price in a normal time. Everything else is a negotiation.

Expired items, damaged goods, discontinued lines, returns waiting to go back to the supplier, and items that have not moved in a year or more are usually excluded or priced at a deep discount. The purchase agreement often says it directly: saleable and usable inventory in good condition, in a normal quantity. Whoever counts decides what meets that description, which is why the question of who counts matters so much.

Some stock does not belong to you at all. Consigned goods sitting in your shop, items customers left for repair, product held on behalf of a supplier, and deposits on special orders that are not yet delivered should all be set aside before anyone counts. If they are tagged and kept apart, nobody argues. If they are on the same shelf as everything else, somebody will count them and somebody will have to take them out of the total later.

A good rule is to clean up in the year before you sell. Sell down the slow-moving stock at a markdown, send back what you can, and throw away what is dead. A buyer will make you do it anyway, and you will get better value on your own timetable.

Count day

In most sales the count takes place the day of closing or the day before, with the buyer and seller each present. For a small shop, that can be a few hours with two people and a spreadsheet. For a distributor or a manufacturer, it can mean a day or two of a crew with scanners, or an outside inventory service that both sides agree to hire and split the cost of. Outside counters are worth the money when the stock is large, because they take a dispute about people off the table.

A full count, shelf by shelf, is the safest. Where stock is large and well tracked, a buyer may accept counting a sample and testing it against the perpetual records in your system, and extending the result across the rest. If your system is not accurate, expect a full count, and expect it to take longer than you think.

Agree on the method in advance. Who counts which areas, how a count is tagged or recorded, how disputed items are marked, whether the seller can recount, and what happens if the two sides disagree on a quantity. In the closing process we describe in the closing, the count is often the last item checked before funds move, and a clear method keeps it from holding up the day.

The cutoff

The hardest piece of inventory work is the line between before and after. Goods you ordered that have not arrived. Goods that arrived and have not been invoiced. Product sold and not yet shipped. Items shipped and sitting at a customer who has not paid. Each of these has to land on one side of the closing date or the other.

The general approach is that the buyer pays for goods that have physically arrived and been received into stock, and the seller keeps the obligation for goods that were ordered and invoiced before closing, or the agreement assigns open purchase orders to the buyer with a credit. The details go in the agreement, so that the day of closing does not feel like a coin toss. A good receiving log, with dates, on the last few days before closing, answers most of the questions before they get asked.

If you hold stock in a third party warehouse or a 3PL, arrange for a count there as well, and a letter from the warehouse confirming quantities. Stock in a truck or at a trade show counts too, and someone should write down where it is.

When the count and the books disagree

They often do. Theft, spoilage, miscounts, an unrecorded return, a part used and never entered. A business can lose a little to these every month, and the book number drifts higher than the shelf number for years. A buyer who pays for what was counted does not care why the book says more. An owner who expected the book number to hold gets a smaller check than planned.

You can find out where you stand before anyone else does. Run a count of your own a few months before listing, compare it to the books, and adjust the books if the difference holds up. A buyer's lender will often look at the cost of goods sold on your returns and ask why the margins on your statements are better than what the physical stock supports. Our post on earnouts, holdbacks and working capital explains how a shortfall shows up in the price after closing if the count was estimated rather than done.

When a deal is an asset sale, inventory is also one of the categories the buyer and seller must agree on for the tax allocation filed on Form 8594, and a high value on inventory means less goes to goodwill. Your accountant should weigh in on that before the purchase agreement is final.

What to do before a buyer asks

Count your stock, price it at cost, and sort it into what you would sell tomorrow and what you would not. Find out how fast each category turns. Tag whatever belongs to someone else. Fix the cost figures in your system so they match recent invoices.

Then write down the way you would want the count to run, and read it as a buyer would. If it takes a page, good. A page is what the purchase agreement will want. At Business Advisors of America we draft this section with owners before a letter of intent is signed, because the terms are much easier to set when nobody is standing in the stockroom yet.

This article shares our opinion and general information. It is not legal or tax advice. Always speak with a licensed attorney for legal advice, and a qualified tax professional for tax questions, before you act.