Tips for Handling Off-Book Inventory During Acquisition

When a deal moves to closing, there’s always a flurry of activity on multiple fronts. The transaction lawyer is busy with the asset purchase agreement, disclosure schedules, and “reps and warranties.” The real estate lawyer is working on the real estate leases. The buyer is working on long to-do lists, and the seller is working on customer and employee messaging. One of the last things the buyer does is perform a hard-count of the seller’s inventory so that the buyer has an opening balance sheet for their new operation. This hard-count happens very close to closing, sometimes just a day or two before, so you don’t want any surprises, which typically come when inventory shows up in the hard-count that is “off-book,” e. g. inventory that is in your yard, but not in your ERP system—and therefore not on your balance sheet.

If you’re the seller and you didn’t know about that surprise inventory, you’d naturally say, “Oh boy, I get paid extra at closing.” Unfortunately, it’s not that simple. During the sale process, you (the seller) have worked with your investment banker and CPA to present monthly balance sheets throughout due diligence that show inventory values. These complement the balance sheets presented when your deal first went to market. The buyer has used these statements not only to value your company, but to make operational assumptions in their budgeting for when they own the company. Even more importantly, the inventory value is among the largest of current assets and a key factor in calculating the working capital “peg” that’s used at closing to determine how much money is left in the company at ownership hand-off.

In addition to potentially skewing the working capital peg, the off-book inventory also presents a problem if the seller demands more money at the last minute. That’s because the buyer has lined up the funds to make the acquisition, often borrowing a substantial portion of money. All the loan documents have been drafted for a closing date-certain, e. g. interest has been calculated and loans are set to close on that day. There’s no money sitting around to pay for unexpected demands. For off-book inventory that shows up late, the seller cannot assume they’ll get paid for it; it may simply be too late. If you have a good investment banker, they can sometimes negotiate a side agreement for an extra check at closing. But often, the seller may have to eat it.

There are ways to avoid this. First, in the near-term, lock down your inventory practices by engaging in frequent cycle counts, especially for fast-turn items such as dimensional lumber and sheet goods. Use these cycle counts to examine how tight your ERP’s inventory is with your hard-counts. If you consistently find more than a 1.5% differential between cycle counts and ERP records, you may have a broader problem in all your categories: your operations may not be capturing every sale to properly deduct it from your available inventory records. Beyond cycle counts, at least yearly internal hard-counts are essential. Preparing for a sale of your company, an interim hard-count (or multi-category cycle counts) is also a good idea. Finally, some sellers have off-book inventory that you know about. It is imperative that you declare this off-book inventory early in the sale process to your investment banker, so they can negotiate it with the buyer and represent it on the balance sheet.

Of all the variables that need to be controlled among the multiple moving pieces of a closing, nothing rattles nerves more than the results of that final pre-close hard-count. Work with your investment banker to prepare long before the closing date is set.

John Wagner is a managing director at 1stWest Mergers & Acquisitions, which offers a specialty practice in the LBM sector.