The importance of Human capital in company valuations

Navigating the complexities of valuing human capital is essential in today’s business world, especially when it comes to mergers and acquisitions (M&A). However, being challenging to quantify, measuring human capital can seem overly challenging…

Intangible company value is typically broken down into research, brand and reputation, technology and software, and human capital (including intellectual property). Research suggests that between 80—90% of company valuations are driven by these intangible assets. Within that, human capital refers to the economic value of the organisation's people's experience and skills. This includes their education, training, intelligence, skills, health, engagement and potential for growth.

If measuring that sounds complicated, it’s because it is. However, quantifying human capital is getting easier. With the right support, businesses and investors can make more informed human capital decisions, supporting improved outcomes by better understanding these hard to measure assets.

Why human capital value is important.

With all that complexity, let's take a somewhat lateral view to help explain.

Imagine you own Downton Abbey!

The upkeep of the house and grounds is expensive and you need to create an income to maintain it. You do this through leasing land, farming etc. You also have a penchant for entertaining and hence, the quality of service provided by your in-house ‘staff’ helps maintain the appropriate reputation.

Logically, it makes sense that you will need to invest in the quality of the buildings, the land, your art collection etc (the tangible assets) and your intangible assets - the quality and skills of your staff, future income generation opportunities etc. in order to grow and sustain the value your assets.

For most organisations, most of the time, investing in human capital - rather than trying to calculate its value is the primary concern. Why so?

Necessary for growth.

The majority of commercial organisations aim to grow and expand as their relative markets do. As such, it’s essential to understand and leverage all sources of capital, including human capital.

If you’re not convinced, McKinsey research might win you over. They suggest that the top quartile “growth companies” invest 2.6 times more in intangible assets than those in the lower two quartiles (increasing to 5.2% in innovation driven sectors). Those companies grew by 20% (median) versus 3% in low growth companies.

You have to invest to generate increased returns

Understanding the value of human capital is possibly better conceptualised at the individual level. It’s easy to buy into the idea that the “value” an individual creates can be improved by investing in their skills, knowledge, engagement etc. Collectively, organisations invest in training, skills development, engagement improvement initiatives etc. to realise the latent potential and grow the value created by their people  — the aim being to enhance individual performance to increase the overall productivity of the organisation.

Asset Mobility

Unlike your tangible assets, you need to worry about the environment you create for your human capital. Human Capital assets simply have the opportunity to walk out the door, taking their value with them, and not coming back. Hence we invest in staff retention initiatives and continued development programs to ensure we maximise our return on those human assets (What would one do if all the butlers left en masse?)

‍

‍

Sadly the time has come to sell Downton as a result of your massive inheritance tax liabilities. The buyer owns a smaller stately home nearby and sees the opportunity to move to the bigger house and create synergies by running the two estates more effectively together. In this instance, it’s obvious that in calculating Downton’s value, we need to understand the value of the tangible assets - easily done with a surveyor and an accountant and the intangible assets - including human capital. Less easily done.

Important for mergers and acquisitions.

In most circumstances understanding the value of your human capital at any particular point is academic. This changes when some form of re-financing, investment or sale activity occurs.

Practically, this involves an assessment of an organisation and it’s employees — particularly in areas integral to the transaction's success, such as:

●      The applicability of their skills.

●      Their experiences and knowledge.

●      The organisation’s ability to attract and retain talent and to nurture, develop, and manage that talent.

●      The organisation’s culture, level of buy in and commitment to its purpose and strategy (employee engagement).

The challenges of putting a value on human capital.

Section image

While measuring human capital can be complex, it’s certainly not impossible. So, why is it so challenging when the necessity of valuing human capital is apparently obvious?

Established methods for other intangibles.

Other intangible assets have established valuation methods, thus giving increased confidence and well understood methodologies for their measurement. However,  human capital valuation has lagged behind. Without hard data and established processes, many organisations either ignore or rely on guesswork when attributing a value to human capital.

Thrown into the “too-hard basket”.

Those experienced in M&A acknowledge that factors like organisational culture and the quality of the leadership team are crucial to value realisation. But, it seems when data and obvious measures aren’t readily available it’s easier for decision-makers to disregard human capital value altogether. In such instances, it really does seem that what gets measured does get focused on!

With up to 90% of an organisation's value wrapped up in intangible assets and Human Capital being a major contributor to that number, it’s concerning - but not necessarily surprising - that 60% of M&A activities fail to be value accretive. When we get underneath what creates this statistic, several HC capital related issues emerge.

The dangers of ignoring human capital value in M&A decision making

How might this failure to appropriately understand human capital value contribute to the worrying statistic that the majority of M&A activities fail to meet expectations?

Reasons for M&A return failures include[1]  overpayment, insufficient due diligence, lack of cultural fit, over extending resources during the transition phase, a lack of market adjacencies, a lack of a strategic plan for the new entity and a misunderstanding of the target company. Clearly this list highlights opportunities for improved Human Capital value assessment to improve M&A effectiveness in the following areas:

Insufficient due diligence and over payment

Underestimating or overestimating the contributions employees make through their skills, knowledge, and abilities leads to inaccurate valuations of the human ‘assets’ that come as part of the deal - increasing the level of Human Capital due diligence helps mitigate risks of over payment.

Lack of cultural fit

Failure to effectively integrate organisations slows innovation and growth. Cultural issues, ie finding ways in which to get the combined entities to work well together - thus generating increased value and or achieving synergies in a timeframe acceptable to shareholders is clearly critical. This could make it hard to retain and recruit top talent, lower morale, stifle innovation, and incur higher operational costs due to increased turnover and lost productivity post settlement.

Understanding the target organisation

Clearly this includes tangible and intangible assets, but with tangibles easier to manage and value, increased risk applies to intangibles. Towards the top the intangibles list surely has to be how the organisation works, its strategy and how (outside of stated processes and procedures) it actually works. Very likely this knowledge is in the heads of the people, especially at the senior level. Increased investigation provides additional insight and hence opportunities for appropriate risk management.

Due diligence when it comes to human capital.

Section image

Given its intangible nature and the myriad factors that contribute to an employee's value within an organisation, placing a value on human capital can be tricky. However, as noted above, increased due diligence is the ideal starting point for this complex process.

So, what needs to be assessed in the due diligence? We’ve boiled it down to five key areas.

1.    Consider ISO Standards.

ISO Standards (ISO 30414:2018) for measuring and reporting human capital were introduced in 2018 and encompass 23 human capital indicators over 10 categories. Interestingly these standards don’t really get to the true Human Capital intangibles - focused on hard data that might indicate (rather than provide insights on) potential concerns.

So, while the ISO Standards are still relatively immature and don't give us a great outcome (yet with some appropriate adjustments - as detailed in future articles[2] ), they do provide helpful insights and should be referred to when performing due diligence.

2.    Explore organisational culture.

Recognising that M&As are often driven by attractive synergies (reducing supply costs, optimising workforces etc) interested parties must assess the potential for these synergies to be realised. This realisation hinges significantly on the cultural fit between the entities involved.

To accurately assess cultural compatibility, reviewing any culture measurement data is essential and - if not - focused interviews with key people should be conducted (on how the company actually works, decision making protocols, how strategy is actually applied etc). This research aims to uncover necessary changes, sentiments towards the integration, and factors that would enable retention of key people..

3.    Assess team & individual capabilities.

This is generally the easiest area to assess, particularly when it comes to management. Start by assessing the qualifications, knowledge, and experience each member brings to the table. Past performance, performance reviews, and any tangible value contributed to the organisation will also help gauge the strength and potential of the workforce.

Identifying key employees (not necessarily in management positions - the cook may of course be more valuable than the “head of the household staff”) goes hand in hand with pinpointing potential risks and formulating strategies for investment risk mitigation. These critical contributors may not be immediately obvious, which is why thorough due diligence is essential for uncovering pivotal assets. This ensures that valuable human capital assets are acknowledged and preserved.

4.    Identify future potential & current retention risks.

Acquirers are unlikely to be able to gather such insights in detail prior to acquisition. Clearly it would be challenging to gain insights into the future aspirations and career plans of all the butlers and valets before the deal is done.However, they can gain insights by reviewing existing data — such as employee engagement surveys and other people related measures within the target company — to evaluate organisational health and morale.   This approach allows acquirers to effectively gauge risks and unearth potential, facilitating a strategic and informed acquisition process.

5.    Integration compatibility.

Successful M&A is not about forcibly merging two organisations; it involves envisioning and creating a new, more profitable and efficient organisation. Acquirers must have a clear vision for the new entity they aim to establish, taking into account the compatibility and potential integration challenges of combining different organisational cultures and structures. This involves an element of self-reflection that acquirers often miss in the context of M&A. For harmonious integration, knowing yourself is just as important as the due diligence you perform on other companies.

Don’t navigate this complex area alone.

Unlock the full potential of your organisation - with Rutherford HR. We’ll help you place the right value on your most important asset — human capital — so you can secure your company’s success (or for help in we may be able to help you buy or sell that large Victorian mansion). Talk to us today to get started.

Add references - see original article references 6,7 and 8)

link to other articles here

‍

‍