How to incorporate obsolete inventory in WC PEG?

March 02, 2022

by a searcher from University of Pennsylvania - The Wharton School in Seattle, WA, USA

How have people managed obsolete/non-saleable inventory in their closing process? For example, I am working on a deal using a standard WC PEG that will adjust the price based on being above/below historical WC needs. One challenge I am facing is that they have some amount of non-saleable inventory that can be quantified at close but there is no historical level. How have people dealt with obsolete info in the WC adjustment process?

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Reply by a professional
from Seton Hall University in Morristown, NJ 07960, USA

While I am appreciating the elaboration, I don't think it changes what everyone else is saying here.Right now, there is inventory on the Balance Sheet that is obsolete and assumed not-saleable.So cash went out to purchase inventory that apparently went bad, but no one wrote it off.GAAP-based financials would have either required the write-off or at least required a reserve against the inventory value.Either way, that inventory would have been an expense, potentially reducing your purchase price.

All that said, the key word there is "potentially".The question comes down to timing.Did that inventory go worthless 5-years ago and you are using the last three years to evaluate your purchase price?Then the seller may be correct.The inventory value would stay constant throughout the calc so a write-off at the end would be harmful to them.But I believe what everyone here is worried about is the fact that you are reimbursing seller for inventory that you most likely cannot sell - so you will never see that money back.And you will be the one explaining why your earnings drop in a future year when you have to be the one to write it off.

I like ^redacted‌ suggestion of paying for it as you sell it.If I am misreading anything in the posts, please feel free to let me know...

Reply by a searcher
from University of Pennsylvania in Seattle, WA, USA

I might not have been clear enough in my question so I will elaborate a bit. My understanding of the WC adjustment is to ensure that there is enough fuel in the engine that the business can run on day 1 post close. I am paying a multiple on earnings and just want to ensure that there is enough WC to support the continued earnings. The question that came up on a recent deal is that the WC PEG is calculated based on average levels looking at the TTM inventory levels for example. The seller was concerned that the obsolete inventory was on the books last year and not written off so writing it off at close would penalize the seller when in reality they believe the WC adjustment already covers this concern and provides enough inventory for the business to operate day 1.

If the inventory peg is calculated as average inventory using 0.5 x (last year inventory + this year inventory), if there truly was the same level of obsolete inventory on the book last year I can see their point. This is the same as: average inventory = 0.5 x (last year good inventory + last year bad inventory + this year good inventory + this year bad inventory).

For me it all comes down to trusting and/or verifying that the obsolete inventory levels are similar across years but I was curious if anyone has run into this before.

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