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Pre-Close Inventory Counts

The vast majority of acquirers require an inventory count, or “hard count” just before the closing. The acquirer typically pays for this service, which is often provided by a 3rd party, and both the acquirer and seller are entitled to have an observer or auditor on-site for the count.

There are four reasons for this hard count:

  1. The seller’s closing balance sheet must reflect the inventory on the ground that’s being passed to the new owner.
  2. The new owner needs an opening balance sheet, not only to comply with GAAP accounting, but for general “financial hygiene.”
  3. The net working capital (NWC), which is the working cash the seller must leave in the business, is typically calculated on a trailing 12-month basis; the value of the inventory over that period is central to the NWC calculation. An inaccurate assumption of the inventory value at close could easily skew the NWC, to favor the seller … or the acquirer. An accurate count assures fairness.
  4. Most deals have a “true-up” 90 days post-close to ensure retrospectively that the NWC at closing was correct, e.g. that all the accruals and pre-paids were in the calculation. If the true-up reveals that the NWC at close was inaccurate, the acquirer may owe the seller some money, or the other way around.

A very active topic of conversation for any hard count focuses on these three inventory categories:

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Shrinkage: There is inventory in your ERP that doesn’t exist in your yard or store. It’s been stolen or thrown out, without a deduction of the item from the ERP. The value of shrinkage discovered in a hard count is a dollar-for-dollar reduction in purchase price. If the count discovers $1,000 in missing fasteners, the purchase price is docked $1,000.

Slow moving: With his permission, I’m using an example of slow-moving inventory from Kodiak Building Partner’s Matt LaScola. If you sell house numbers, you have to buy them in sets of 0 through 9. You will use up the 1s, 2s, and 3s faster than the rest of the numbers. Yet you have to keep a full complement of numbers on-hand.

Now apply that to 200 SKUs from SST or MiTek. You’ll sell far fewer triple beam hangers than you will hurricane ties, but you have to keep the hangers on-hand to maintain a full range of products. That’s slow-moving inventory; most acquirers recognize that some things sell faster than others but that the inventory has value to them.

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Obsolete: Of the items that get negotiated near a deal closing, the definition of obsolete inventory is the No. 1 topic. The standard today is that something that doesn’t sell for more than 12 months is obsolete. Say your hard count (when compared to your ERP) discovers $5,000 of inventory that fall into this slow-moving category. You, the seller, will be docked $5,000 from the purchase price (unless you have accrued for obsolete inventory in your financial model). The inventory ruled obsolete reverts to the seller.

The costs of preparing for an inventory: Even though a third party is probably doing the pre-close hard count, and the acquirer is paying for it, there is still some prep (and costs) that you, the seller, will have. Given that acquisitions can happen at any time in the year, a pre-close hard count may take place outside of the cycle when you’d traditionally do a hard count. That may mean staying open late into the night or bringing in your own staff for organizing the inventory ahead of the count, and then sending in staff to audit the process in real time.

When negotiating your deal structure, lean heavily on your investment banker to sort out the inventory distinctions and get the categories defined as early in the process as possible.

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