In the March 1999 ABI Journal, there was an article entitled, "Retail Restructuring: It's Not Just About Inventory" written by Jeffrey Wolf and Stewart L. Cohen. The article discussed the potential of avoiding the liquidation of inventory, and raised these questions: What is the inventory worth as a standalone asset for the benefit of the estate? How should the inventory be sold for the highest benefit to the estate? What areas affect the value that might be considered? Here are a few thoughts from a different perspective.

Intangibles May Be a Part of the Inventory

Intangibles and goodwill are typically assets of an operating business and are measured by the difference between the measured tangible properties subtracted from the purchase price. Intangibles can include franchises, trademarks, trade names, licenses, recipes, patents, goodwill, client lists, non-compete agreements, business books and records, work force, permits, copyrights, etc. These intangibles can be assets if they are transferable to another party by the subject. In many cases, licenses are given where an asset purchase would not allow a transfer, whereas a corporate ownership change could retain that right. In the one instance there would be no value, while in the other there would be a possible assignment of worth.

These issues have been the subject of discussion since 1993, when intangibles were allowed to be depreciated by a new provision in the Internal Revenue Code referred to as §197. The 15-year straight-line amortization of these intangibles does not apply to those created by the ongoing business, but rather to those purchased in an exchange of the business from one party to another.

Acquiring the inventory of a manufacturer, licensee or owner of the intangible rights may or may not empower the possessor with the ability to transfer certain intangible parts of the product, even though in some cases the court can permit some transfers not allowed under other proceedings, such as foreclosure under a security agreement. Consider the following possible scenarios:

1. Finished products where the manufacturer has failed and the seller of the inventory must convert the last of those finished items into dollars. The trustee may not be able to transfer warranties since the manufacturer has failed and there will be no one to honor these. If this is the case, an intangible will be created. This will be a loss of value due to the manufacturer's demise for warranty support.

2. A sale to a third party of the inventory separate from a reorganization plan of the business assets, as the consideration is to raise funds for a special purpose, or the plan proposes a new direction for products. There is an incentive to do this, but there is the possibility that it is not the best choice for the highest recovery to the estate. When there is a bulk sale made of the inventory as of a specific point in time, and the manufacturer continues to make more of the same proprietary products after the sale, there is the possibility that no rights of manufacture, trade name, trademark or license agreements are included, but rather the sale would be only for the inventory items. This situation requires an expected value that is affected by the typical adjustment for the loss of those rights that are not transferred. For some generic type items, this may be of little or no consequence, whereas for other areas in which there is a requirement for the continuation of supplying a customer base, use of a trade name or other such things, the effect is possibly profound.

For example, assume an inventory of new motors is used to manufacture a special down hole pump. The motors are purchased outside and appear to be standard. If, however, these motors are specially wound for these particular pumps, and no one else can use them, then this must also be a consideration for the finished product. If the company stops manufacturing these pumps or sells the inventory without support, there are no return privileges, warranties, guarantees or back-ups for the finished product, and therefore, those pumps are going to be discounted dramatically in order to sell them to another party who has knowledge of these facts.

The opposite would be true in the example of the manufacturing of lawn mowers or trucks that have standard off-the-shelf engines staged to produce the finished product. Even if the company stopped manufacturing its proprietary items, the Briggs and Stratton, Wisconsin, Cummins or Detroit engines could still be acquired, supported and, in all probability, sold under warranty. The fair market value or liquidation value for the pumps as a proprietary product would be far different as a percentage of cost than the lawn mower or truck example.

3. The transfer of ownership of only one or a few stores of an enterprise that has a network or national operation that is not affected by that particular sale. This could occur when a plan of arrangement is the closure and sale of stores to continue with the balance. Many refer to this as the trade name or private label issue. Some department stores or tool and appliance stores have experienced this situation where the chain's policy allowed return to any of their outlets. Under the transfer of ownership scenario, the balance of the chain would not be required to honor returns or warranties for any reason, and therefore, as a part of that sale, there would have to be an identifying process to the subject to allow for that protection. In any event, this type of inventory would be subject to balances in such things as sizes, colors, patterns, models, etc. If no more could be purchased, then this would have an effect on the value of the remaining portion that was offered—"a one-time sale." This would not necessarily be the same for inventory that would be referred to as "national brands," in which warranties, return privileges or additional purchases could be made using an outside supplier; an exception to this would be a license or supplier agreement that would not be granted to the new owner of the subject inventory.

4. An inventory owned by a manufacturer that provided a private label for another in which a transfer of ownership did not allow the transfer of the identifying mark. This occurs where outside manufacturers are supplying a proprietary product under contract. Many times, this type of inventory can be affected by too much quantity, limited style or size, or other factors associated with a one-time sale. However, the issue is still the value measurement of assets in which there must be a separation of intangibles due to the lack of transferability of a certain attribute of an asset. This is sometimes referred to as a "contract issue." Does the sale not carry with it the right or requirement of the contract buyer to accept the subject proprietary or labeled merchandise?

The above four examples may not necessarily cover everything, but they certainly bring up the problems associated with the measurement of inventories where certain scenarios are imposed. Remember, fair market value assumes a willing buyer as well as a willing seller, and how that buyer is affected by the imposed limitations will affect the assumed price to be paid, thereby affecting the value. By that same logic, liquidation concepts used in bankruptcy are also affected. The appraiser must deal in probability rather than possibility as it relates to product line or intangible transfers under any concept of value. The trustees or attorneys involved in these cases must also appreciate these points when making sale decisions.

The appraiser must be ready to address these issues if the scope of the project requires that type of measurement. Even under level-of-trade issues, consideration must be given for the most likely buyer or candidate due to the imposed restrictions. In many cases, the only purchaser is a second-source buyer because of a one-time purchase of the inventory that may be effected. Even if the buyer were to use the inventory as a foundation or base for continuing the business of retail sales, manufacturing, wholesaling or distributing, there is a real-world and real-value implication imposed on that type of inventory.

Value Understanding for Inventory

A sale to another party is the exchange of title. If both seller and buyer are willing, regardless of the exchange, liquidation value is not imposed, but fair market value is. This understanding is read and defended by most appraisers, documents and published definitions. Unless there is an exchange of the enterprise in which intangibles are also exchanged, there is a different impact to the value of those assets. If one considers the value to the current owner, there is certainly a difference from that measurement when there is a transfer to another owner without the entire "bundle of rights."

If one were to continue the business without all of those rights, there is the effect of that loss of rights on the value that is being assigned. Liquidation value has the same consideration, but the economic obsolescence is historically higher due to such things as stigma, typical buyer reactions for an expected bargain, advantage-taking and so forth. In other words, the other effects may be the same, but there is an additional possible deduction based on the buyers' reactions in a "forced sale" type disposal. This is not always the case, as there are exceptions that may be understood and applied to offset the typical economic factor in these types of situations.

Confusion exists in this area as to the proper depreciation that could impact inventory. Inventory is typically measured as a cost to the owner. This is especially true when reporting the assets for allocation under IRS regulations or for consideration by assessors for ad valorem tax. Regardless, "cost" must include a deduction for any depreciation factors implied by the law and its interpretation. This is understood as an adjustment for the unique characteristics of particular assets. Many do not do this, or may not even know how when preparing bankruptcy schedules that reflect the total burdened cost of the inventory.

Level of Trade

Differences in value may occur under laws throughout various states or even counties depending upon a law or code. On new inventory, it is correct to start with replacement cost at the current "level of trade." This is the comparative measurement to which all purchases of inventory express value after depreciation (if any) has been taken. The expression of that value would certainly be different to the enterprise that includes fixtures, equipment, leasehold improvements or real estate and all business rights, as compared to a sale in exchange (buyer and seller) of that same mentioned inventory at a given point in time. Perhaps this insight may allow an understanding of an appraiser's opinion of value in which two sides of an issue indicate values that seem to be unreasonably different. Both appraisals may be correct if the assumptions are different. Although this should be spelled out in the report, it may be that this article will assist in the understanding of the impact of intangibles on inventory value.

Liquidation value may not be impacted by the level of trade on one-at-a-time sales of individual assets. This is typically a sale to the marketplace and anyone that could be a buyer. As an example, assume that a manufacturer of outdoor furniture is being sold where the business will not continue. The fair market value of the inventory of that manufacturer, or anyone that would take its place, would be a replacement cost less depreciation factors. If sold individually at public auction or orderly sale, the finished inventory could possibly bring more than cost to the manufacturer, but less than cost to a retailer or a retail price. This is a good example of the "level of trade" issue.

What is expected by the seller as value in a sale? If a seller sells a manufacturer's inventory to another manufacturer, the expected value is different than from one wholesaler to another or from one retailer to another. This does not stay the same when the expected buyer is an end user of the item, which may raise some numbers. However, there are other factors that can change the expectation for higher numbers on everything in the inventory make-up. Many of these things were previously stated, but for the level of trade issue there can be different quantities at each level. The wholesaler or retailer may not be able to absorb the quantity of a manufacturer at all levels and, at the very least, would expect a discount or incentive to purchase.

Cost Is Not Value

Accounting for tax considerations and value for one title exchange to another is not the same thing, but in some cases, they can be the same number. An example of this would be a steel inventory that may have been purchased at a depressed price, while the current price is much higher. Further assuming that there are no unique features to the steel, and that it is all standard and could be utilized by anyone, the fair market value may be higher than the cost. Under the accounting standards (GAAP), the inventory is kept on the books at the lower of the two—cost or market. This means that even the books would reflect a lower tax value than market value. If the opposite costs for the steel were true, it is possible that the company would recognize the lower market and adjust it as they have the right to do. However, the price may move up and down over time, and the adjustment may not be recognized. In most cases, the owners of inventory do not recognize the adjustment without some special requirement to measure it or to value it through an outside expert. The steel example is easier than using a proprietary product or other items that more subtly change in value. In addition, the value to an ongoing operation can be far different than that at which it would sell in an exchange. Add the additional factor of bankruptcy, and that incentive to purchase may be greater than it would be under the "forced sale" scenario.

Conclusion

This article is a not directive of how to value inventory, but rather a guide to understanding the potential recovery that can be expected. It may help to point out deficiencies in value conclusions or to raise possible questions. See Inventory Definitions below.

Inventory Definitions

There are a few definitions for "inventory" that might allow a communication tool for an understanding of another definition that is directed to indicate value.

Orderly Liquidation Value Through Continued Operation is "the estimated gross amount, expressed in terms of money, projected to be obtainable, over a finite period, for an inventory sold under the direction of a forced type seller. The express intent of sale in this manner is liquidation through continued operation of the entity, with the seller responsible for all operating expenses and the beneficiary of all sale proceeds."

Comment: Orderly Liquidation Value Through Continued Operation is intended to be applied in circumstances where a presumed overnight disappearance of a subject entity has been deemed unlikely. These circumstances can include an inventory that is so large in composition, or so dispersed with regard to location, that the market into which the inventory is to be tendered has an insufficient capacity to absorb all items within the limited time frame. This can occur in situations with large overall market shares or the geographic domination of a particular market. There are many of these types of sales in which the results can equal fair market at the subjects' levels of trade. In bankruptcy, this scenario is less likely.

Other circumstances can include situations where there is a captive customer base in the sense that a transition period would be required, during which the customer would locate a suitable replacement. This factor tends to occur in situations where the inventory mix is relatively complex and would require the location of several different sources to maintain mix continuity. This can also occur when the subject is the single source of supply.

Generally, the method of valuation under this definition is to segregate the inventory for sale into both levels of trade under consideration. The liquidation marketing period is divided into two distinct groups. For the first liquidation period, typically 30 to 90 days, the inventory will continue to be sold to the existing customer base and is valued at some expression of the current sales price. The second liquidation period begins immediately and sales to the customer base are suspended. All remaining inventory is sold to purchasers at the same level of trade as the subject and is expressed as a percentage of cost. The weighted average of recovery for both periods is the final expression of value. A plan of arrangement could include this type of liquidation.

As an example of this methodology, the subject is a distributor of chairs and maintains the following line item of inventory:

Description	Qty.	Unit Cost	Unit Retail
Chair, Dbl. Ped.	100	$10	$20

It has been determined that a 30-day transition period will be required for the majority of the customers to re-supply, and that a continued operation of the subject company over this period benefits all parties concerned (e.g., customers, company principals and secured parties). Based on the past 12-month history for this line item, it is found that 40 of the on-hand quantity of 100 will be absorbed at the customer level over the 30-day time frame. The remaining 60 will be sold to competitors, brokers, et al. at discounts against cost.

Orderly Liquidation Value Through Continued Use is "the estimated gross amount, expressed in terms of money, projected to be obtainable over a finite period for a manufacturer's inventory sold under the direction of a seller. The express intent of sale in this manner is completion of some elements of work-in-process inventories into finished goods through continued operation of the entity, with the seller responsible for all operating expenses and the beneficiary of all sale proceeds."

Comment: The language in this concept is very similar to the continued operation definition, with the primary difference being the presumed completion of some elements of work-in-process. The reason the word "some" is used is to allow the valuer maximum flexibility in determining which elements are subject to justifiable completion. Typically, the test of justification rests upon some type of cost/benefit analysis, especially since the seller will be responsible for any completion expenses.

In the appraisal of inventory under this concept, the raw materials must be separately apportioned into those that will be used up in the completion process and those that will be liquidated as is. This can be a very complex analysis. For example, consider a manufacturer of steel. Such a manufacturer may make steel through any number of processes, from coke distillation to the melting of scrap. In addition, there are often a large number of alloy materials; even such items as supplies must be taken into account. Assuming the appraiser has identified that a certain number of pre-existing orders can be filled in which maximum recovery far above the liquidation of the raw materials "as is" could produce; the next step is to identify which raw materials and what quantities of each will be required. This is in addition to the actual work-in-process because, in this case, a combination of this and conversion of some raw materials is indicated. In this scenario, a seller, to maximize recovery, may in fact have to purchase some raw materials to keep the inventory in balance as the liquidation goes forward. Generally, finished goods and unused raw materials under this definition will show the same recovery as under any other orderly liquidation concept.

Orderly Liquidation Value is the estimated gross amount, expressed in terms of money, that could typically be realized from a sale, given reasonable time to find a purchaser(s), with the seller being compelled to sell on an as-is/where-is basis.

Comment: This is the valuation concept most frequently used by asset-based lenders and those referred to earlier. Its primary attribute, "realized from a sale," provides maximum flexibility to the presumed liquidator in both methods of disposal and timing.

Forced Liquidation Value is the estimated gross amount, expressed in terms of money, that could typically be realized from a properly advertised and conducted public sale, with the seller being compelled to sell with a sense of immediacy on an as-is/where-is basis.

Comment: The key component here, as it applies to inventory, is the word "public" as opposed to auctioning. Inventory is generally sold at an auction only as a last resort or as a means to increase a sale's draw. Sealed bid sales are frequently used to dispose of the inventory far in advance of any auction; in some cases, the personal property is incidental to the liquidation at best. In these instances, the word "public" is interpreted to mean "generally known." For example, in the case of a liquidation sale of a proprietary product line in which the only interest would be from competitors, or possibly other unknown investors, the exposure to the "public" is realistically limited to only those interested parties, as opposed to the general public. The term "public" also implies a competitive bidding process at the end of which a determination is made about which bid is accepted. The sale can be at an auction, but for inventory, the sale can often be the result of a sealed bid process.