Company Valuation with Fixed Assets and Inventory

July 18, 2023

by a searcher from University of Texas at Austin in Austin, TX, USA

Broker and I are spot on with company valuation. Except on top of that he wants to add inventory (~$1.5M) and fixed assets (~$300K).

Company is B2B distribution, so for inventory think industrial cleaning supplies or machine parts (they sell goods and installation services). There is no Work in Progress inventory. Fixed Assets from the balance sheet include displays, trucks, fixtures, computers and "leasehold improvements".

How are these two items (inventory, fixed assets) typically handled in SMB company valuations?

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Reply by a searcher
from State University of New York (SUNY) in Buffalo, NY, USA

This one drives me nuts. As a business buyer you should pay for the assets or a multiple of the cash flow, but not both. As others have pointed out, those are the assets required to generate the cash flow of the business, so they should be included. Many owners and brokers struggle with this concept, so might be worth seeing how it impacts your multiple and if you’re still comfortable if you paid for them separately. I’d suspect in this case an addition $1.8mm of purchase price will significantly increase your multiple and cause the deal not to pencil from a DSCR perspective.

One salve is to have the seller hold back the $1.5mm of inventory and buy it at cost from him. Basically consignment inventory. After a year or 18 months, anything not sold transfers to you at no cost where you can dispose of it to free up warehouse space. This way you aren’t paying for dead inventory. One caveat is if the seller has not been writing off obsolete inventory on a regular basis, their EBITDA is overstated. Buying inventory that never sells is a real cash cost of the business. Hopefully you can do better going forward as a lot of SMB owners aren’t sophisticated inventory planners / managers, but it could be an industry driven factor that will persist. If after a year, say $1mm of the inventory hasn’t been sold which was accumulated over the last 4 years your earnings in each of the last 4 years was overstated by $250k each year.

Reply by a searcher
from Tufts University in Jersey City, NJ, USA

It sounds like you and the broker are thinking in terms of two completely different valuation methodologies. In a cashflow-based valuation (multiple of EBIT or EBITDA, etc) the normal operating assets of the business are assumed to be factored into that valuation, as the cashflow that is the basis of that valuation does not exist without those assets. If the assets of the business are particularly nice/high value in a way that arguably will create better future cashflow than a comparable business, then that presumably reflects in a higher multiple.

An asset sale is a completely different approach to valuing the business. The broker can't have their cake and eat it too: either this is a cashflow-based valuation or an asset-based valuation. Trying to get the value of both is inherently double-counting.

The one exception would be if there's significant excess inventory/equipment/facilities that don't fall within normal operating inventory and aren't contributing to the underwritten cash flow. The seller should get credit for those. For example, if the company uses 10 widgets a month and their normal operating inventory is 50 widgets but they got a really good deal on a bulk order of widgets and have 100 on hand at the time of the sale, it's fair for them to argue that they should get paid out for the COGS of those 50 excess widgets.

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