Why high stock levels are a problem when selling a business (and what to do about it)

If your business requires a lot of expensive stock to run you may have a problem to overcome when you sell. Even if this doesn’t describe your position, it’s an interesting issue that gives you an insight into the buyers’ market, so read on….

Why is high stock value a problem when selling a business?

It all stems from how businesses are actually priced. Businesses are priced on a multiple of usually between one and three times yearly profits. This range can vary greatly depending on where the market is and the risks involved in the business, but let’s say for argument’s sake that an average business will fetch three times profit on the market. This represents a problem for businesses with high stock levels.

To illustrate this problem, let’s use two similar examples.

This is Sam.

 Sam’s business returns a profit of $300,000 p/a after owner’s wages. He has good financial documents and a relatively safe income stream, so his business is valued on three times earnings.

Sam’s Business with $300,000 profit at three times earnings = $900,000 asking price.

 

This is Jennifer.

Jennifer’s business also returns $300k profit after owner’s wages. It’s also a safe business and has all financial documentation meaning that it is also valued on three times profits. The only difference between Sam and Jennifer’s business is that Jennifer’s business also has about $600,000 worth of stock that will need to be sold with the business.

Jennifer’s Business with $300,000 profit at three times earnings = $900,000 + $600,000 stock. Which means that Jennifer will need to ask for $1,500,000 asking price. 

But will she get it? Unfortunately not… and here’s why.

When a buyer is searching for a business, they will search for the greatest return on their investment. When faced with a choice between Sam’s business and Jennifer’s business this is what they’ll see:

You can see why Jennifer, with her high stock levels now has a problem. On the market, despite her business being almost identical, it is not going be nearly as attractive as Sam’s and it is very likely that she will struggle to find a buyer without significantly dropping her price.

Does this mean that stock has no value in a business sale?

Not exactly. Stock definitely has value, but on the business sales market, the substantial increase in initial investment means that it’s value can actually impede your business sale and make your business unattractive to the market.

So how could Jennifer solve this problem? There are three ways. She could:

1. Reduce the investment by working down her stock levels to essential stock only. This will work for some businesses, however, if your business needs very high stock levels to run, then this first option isn’t an option at all. It also still means that the business will still need to go onto the market at a higher price than non stock-heavy businesses, so it may not quite solve the problem anyway.
2. Sell the stock to the buyer on consignment. Jennifer could offer terms whereby an incoming vendor could buy the stock as they sell it on consignment. For the buyer, this would allow them to enter the business at a much lower initial investment cost, and for Jennifer it would allow her to sell her business with the stock at full price- only the stock values would take much longer to be returned.
3. Offer vendor finance on the stock to remove her buyer’s concerns about high initial investment. This would allow the business to be marketed at as close to $900,000 as possible (it’s core value) and the stock be paid for in full ($600,000) over a set, negotiated period of time. Some discount to the business value may have to applied due to the cost of vendor finance if any. This may be preferable to consignment as it would remove the risk of stock not ever selling and it sets in place a timeframe for the return.