In an M&A transaction, working capital is often one of the most misunderstood—and heavily negotiated—components of the deal. Many assume that taking inventory is as simple as counting what’s on the shelf and multiplying by cost. But experienced buyers know better: if finished goods inventory can’t be monetized at or above its historical cost in the normal course of business, it’s not really working capital at all.

M&A attorneys who don’t understand the implications of the distinction between historical cost and fair market value in the context of inventory may leave their clients exposed to unexpected financial risks. This article explores why inventory valuation isn’t just a bookkeeping exercise—it’s a critical component of assessing the business’s ability to sustain profitability post-closing.

Historical Cost vs. Economic Reality in Inventory Valuation

Under GAAP accounting, inventory is recorded at historical cost, meaning the actual cost incurred to purchase or manufacture it. However, in an M&A transaction, a buyer isn’t concerned with what the seller paid for inventory in the past. The buyer cares about whether that inventory can be converted into cash or sales revenue at or above cost in the normal sales cycle.

When Inventory Value on the Balance Sheet Doesn’t Match Reality

While historical cost governs working capital calculations, the true economic value of inventory matters because:

1. If Finished Goods Are Overpriced Relative to Market Demand, Future Margins Shrink Example: A seller’s finished coolers cost $20 per unit to manufacture, but due to lower raw material costs and increased competition, they can now only be sold for $18 per unit. The inventory is booked at $20 per unit, but in reality, its true economic value is $18 per unit—meaning the buyer is inheriting a hidden loss.
2. If There’s Excess Inventory Beyond Normal Operating Needs, It’s Not “Real” Working Capital A seller who overproduced before the sale to make financials look stronger may be carrying more finished goods than the business typically needs. If inventory levels exceed what’s required for normal sales, buyers may exclude the excess from working capital calculations.
3. If Inventory is Slow-Moving or Becoming Obsolete, It May Require a Write-Down If finished goods have been sitting unsold for too long, the market may no longer support their recorded value. Buyers will scrutinize inventory aging reports to determine whether certain products should be discounted or written down.

Working Capital Adjustments: Where Buyers and Sellers Clash Over Inventory

Why Historical Cost is Used in the Working Capital Adjustment

• The working capital peg is based on GAAP-compliant financial statements, which value inventory at historical cost.
• GAAP does not allow inventory to be marked up to fair market value, only written down if necessary.

Why Buyers Still Care About Fair Market Value

• Buyers analyze whether the inventory can actually be sold at its recorded cost—because if it can’t, they inherit an immediate margin squeeze post-closing.
• If a significant portion of working capital is overstated due to overpriced, excess, or obsolete inventory, buyers will push for adjustments before closing.

Common Negotiation Points in M&A Deals

Buyers protect themselves in several ways:

1. Scrutinizing Inventory Aging Reports If a large portion of inventory is slow-moving, buyers may argue that it should be excluded from the working capital peg.
2. Assessing Sales Velocity & Market Pricing If finished goods historically sell within 60 days, but the seller is carrying 120 days of inventory, buyers may challenge the reported working capital. If market conditions force price cuts, buyers may seek a purchase price adjustment to reflect future expected losses.
3. Negotiating Exclusions for Excess or Obsolete Inventory Some deals carve out slow-moving or excess inventory from the working capital calculation. Other deals build in a post-closing true-up, allowing buyers to adjust for any valuation discrepancies.

Bottom Line: Inventory is More Than Just a Number on the Balance Sheet

If a buyer cannot monetize finished goods inventory at or above its historical cost in the normal sales cycle, then that inventory does not serve its purpose as working capital. M&A attorneys who fail to grasp this distinction may leave their clients vulnerable to:

• Overstated working capital calculations, leading to an inflated purchase price.
• Post-closing margin compression if finished goods must be discounted to sell.
• Surprise inventory write-downs, eroding expected profitability.

The Takeaway

Taking inventory in an M&A deal isn’t just about counting what’s on the shelf. It’s about understanding whether that inventory represents real, monetizable working capital or a de-facto hidden liability.

THIS ARTICLE IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE LEGAL ADVICE.

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