Latest / The Buyer & Seller Podcast with Fexingo: Business Brokers, Exits, and Private Sales Explained / How Inventory Quality Determines Business Sale Price
Transcript
- Lucas: We spend a lot of time talking about earnings, recurring revenue, and customer concentration. But there is one line item on the balance sheet that quietly destroys deals in retail and light manufacturing: inventory. Luna: I see this all the time. The seller sees a warehouse full of product and thinks it is an asset, but the buyer sees a liability waiting to happen. Lucas: Exactly. And the disconnect usually happens because the seller values inventory at historical cost, while the buyer values it at what they can actually sell it for tomorrow. Let us look at a specific example from late last year involving a mid-sized home goods distributor based in Ohio. Luna: Was this a brick and mortar operation or mostly wholesale? Lucas: It was a hybrid model. They supplied independent boutiques across the Midwest with decorative items and seasonal decor. On paper, the company reported twelve million dollars in annual revenue and roughly two million dollars in adjusted EBITDA. The initial offer was eight times earnings, which put the enterprise value around sixteen million dollars. Luna: That sounds like a healthy multiple for that sector. What went wrong during due diligence? Lucas: The buyer brought in a third-party logistics consultant to walk the warehouse. They found that thirty-five percent of the inventory was older than eighteen months. In the home goods space, trends shift fast, and what was trendy last spring is dead weight by this fall. Luna: So the buyer didn't just discount the price; they likely demanded a massive working capital adjustment. Lucas: They did. The buyer argued that the seller had been carrying dead stock on their books for years, essentially using buyer money to store obsolete products. They valued that old inventory at five cents on the dollar, which is basically scrap value. Luna: That is brutal. It turns a ten million dollar asset into half a million. Lucas: It reduced the deal value by nearly four million dollars. The final sale price dropped to thirteen million, and even then, the seller had to agree to buy back any unsold inventory at the end of the first year post-closing. Luna: This makes me think about how sellers often ignore the aging of their stock until it is too late. Do you see this more in retail or in manufacturing? Lucas: It hits both, but the mechanics are different. In retail, it is about fashion cycles and seasonality. In manufacturing, it is about raw materials and finished goods that may become obsolete if a client changes suppliers. Luna: Right. A manufacturer might have steel on hand that they bought at a low price, but if the industry standard shifts to aluminum, that steel is worthless. Lucas: Precisely. And the interesting part is that many small business owners do not track this rigorously. They rely on quickbooks summaries rather than detailed sku level aging reports. When the buyer asks for the granular data, the seller realizes their own numbers are fiction. Luna: So the first step to fixing this is having a clear aging report. What are the standard buckets buyers look at? Lucas: Standard practice is to segment inventory into three buckets. Current stock, which is under six months old and sells within normal cycles. Slow-moving stock, which is six to eighteen months old and requires some effort to move. And obsolete stock, which is over eighteen months old and has little to no market demand. Luna: And the buyer will only pay full value for the current bucket? Lucas: Usually, yes. For slow-moving stock, they might pay eighty percent of the book value, assuming they can liquidate it within a reasonable timeframe. For obsolete stock, they either exclude it entirely or offer pennies on the dollar. Luna: This feels like a lesson in operational discipline. You cannot hide bad operations behind good revenue. Lucas: Exactly. Revenue looks good on an income statement, but if that revenue came from moving product that is now sitting in a warehouse rotting, the quality of that earnings stream is questionable. Luna: Does this apply to service businesses as well, or is it purely a product play? Lucas: Service businesses have less physical inventory, but they have digital or contractual inventory. Think about a software firm with unpaid licenses or a marketing agency with unused ad spend credits. Those are form of inventory that can bleed value if not managed. Luna: I had not thought of ad spend credits as inventory. That is a clever way to frame it. Lucas: It works. If you have fifty thousand dollars in pre-paid media buys that haven't been used, the buyer has to decide whether to inherit that obligation or ask for a cash refund. Luna: Which brings us back to the original point. Sellers need to clean house before they list. How far out should they start doing this? Lucas: Ideally, you should be cleaning inventory two years before you plan to sell. That gives you time to run promotions, bundle slow-moving items, or write off obsolescence proactively rather than being forced to do it during due diligence. Luna: Proactive write-offs hurt the bottom line in the short term, but they protect the multiple in the long term. Lucas: That is the trade-off. A smaller profit today is better than a lower valuation tomorrow. Buyers respect transparency and cleanliness. They fear hidden liabilities. Luna: Let us take a brief pause here to talk about how we keep this network running. A couple of dollars a month is genuinely what keeps these going, specifically things like the research and editing that go into every script. If you have gotten something out of them, check out buy me a coffee dot com slash fexingo. It helps us stay ad-free and independent. Thanks for supporting the work. Lucas: Back to the deal dynamics. Once the buyer identifies the obsolete inventory, how do they typically negotiate the rest of the purchase price? Luna: Do they use the inventory discrepancy as leverage to drop the overall multiple, or do they just adjust the working capital? Lucas: Smart buyers do both. They adjust the working capital requirement for the immediate cash impact, but they also argue that poor inventory management signals deeper operational issues. They might say, 'If you could not manage your stock, how can I manage your supply chain?' Luna: That is a psychological play. It shifts the conversation from math to trust. Lucas: It does. And once trust is eroded, the buyer becomes skeptical of every other number. They dig harder into accounts receivable and payroll. One weak link exposes the whole chain. Luna: So the advice for sellers is not just to count the boxes, but to prove they understand the lifecycle of their product. Lucas: Yes. You need to show that you have a system for rotating stock, a policy for markdowns, and a habit of writing off losses annually. It shows maturity. Luna: What about consignment inventory? If a retailer holds goods on consignment, does that complicate the valuation? Lucas: It complicates everything. Consignment means you do not own the inventory, so it should not be on your balance sheet at all. If it is, you are overstating your assets and understating your liabilities. Luna: That would be an instant red flag for any serious buyer. They would question the integrity of the entire financial statement. Lucas: Absolutely. It suggests the accounting is sloppy. And in M&A, sloppy accounting is code for hidden risks. Buyers will assume that if you messed up the inventory classification, you might be messing up the tax filings too. Luna: So accuracy in classification is just as important as the actual count. Lucas: It is. You want your balance sheet to reflect reality, not optimism. Optimism belongs in the sales forecast, not in the asset register. Luna: One last question on this. If a seller finds themselves in this situation, with a lot of old stock, is there ever a scenario where they can still get a high multiple? Lucas: Only if they are strategic. If they can prove that the old stock is tied to a long-term contract that guarantees sales, it might hold value. Or if they can demonstrate a rapid turnaround plan that the buyer can execute immediately. Luna: But that puts the burden on the seller to convince the buyer they can fix it. Which is hard when you are already losing credibility. Lucas: Right. Prevention is always cheaper than cure. Clean inventory leads to clean deals. Dirty inventory leads to broken ones. Luna: It seems like the best time to worry about inventory is right now, while you are still the owner making the decisions. Lucas: Exactly. Control your warehouse, and you control your valuation. Let go, and you let the buyer dictate your price. Luna: A practical reminder that operations and finance are not separate silos, they are the same thing. Lucas: They are. And in the end, the most valuable asset you can sell is a business that runs without you needing to explain away its flaws. Luna: So, what is the next step for a listener who realizes their inventory is a mess? Start the purge now. Lucas: Start the purge. Count everything, age everything, and write off what doesn't belong. It hurts to see the numbers drop, but it saves the deal. Luna: Clean books, clean warehouse, clean exit. Lucas: Clean exit. We will see you next week.