When we apply the Justification of Purchase (JOP) test to check the reasonability of a value conclusion, we ask:
1. Can the business pay the owner-manager fair market compensation?
2. Can the business adequately service assumed and acquisition-related debt?
3. Can the business earn its owner a satisfactory return on investment?
There are many important assumptions implicit in the JOP test. If they are not valid, the JOP may not apply:
1. We are valuing equity, not assets – a stock sale, not an asset sale, is assumed.
2. The business is and will be a going concern. If not, we use a liquidation premise and consider net asset value.
3. The business is sufficiently profitable to generate cash flow after (net of) owner-manager compensation. If not, it is just a hobby.
4. The business is sufficiently profitable to generate cash flow after (net of) compensation and debt service (interest and principal). If it is not, it will go bankrupt.
5. The business is not just a “buy-a-job” operation. If it is, then question 3 above is not relevant; no return on equity is expected. But questions 1 and 2 still apply.
6. The relevant ownership benefit metric is cash flow to equity (not just profits). Owner-manager compensation, debt service, and return on equity must all be measured on a cash flow basis. Owners cannot pay their salaries, dividends or their lenders “profits”. All of these must come in the form of cash.
Finally, when you use the JOP, be careful when part of the equity value comes from non-operating assets (like excess cash or owned real estate). Deduct this amount from the total equity value to arrive at the value of the business excluding it. THAT is the price used in the JOP. The non-operating assets are valued separately; the buyer will pay 100% of their value in addition to whatever the value of the business (excluding the non-operating assets might be.