IPM Ventures

Human capital and valuing workforces

In the age of the knowledge economy, the competition for talent exists in both new and old economy business sectors. Today human capital in the forms of the talents, skills and knowledge of the workforce is being recognised as having a capital value in a very tangible way. A trained and assembled workforce is an integral part of the revenue stream of a business, and so is an important asset class in its own right.
There have been numerous court cases (particularly in the US) confirming that the workforce can be properly identified as having a separate measurable value. But how can a work-force be valued as an asset?
It is a fundamental principle of valuation theory that the value of any asset or liability is the present value of future economic benefits or losses that can be anticipated to accrue to the owner of that asset or liability.

Valuation is not a science, and there is no universally accepted valuation methodology, however there are three general categories of valuation methodology in the valuation of any intellectual asset. These are the cost approach, the market approach, and the income approach.

The cost approach is used to arrive at the value of the asset by ascertaining the amount required to replace the asset. The underlying assumption is that the price of the new asset is commensurate with the economic value of the service that the new asset can provide during its life. The main disadvantage of this method is there is no correlation of cost with value. Compare the value of the micro-chip which is measured in billions, and the cost to invent it, which was minimal, or the respective costs to create and market value of new software technology which never actually works.

The market approach, arrives at the value of an asset by comparing valuations derived from similar asset classes in published transactions. But this depends on an active and public market, with a record of exchange of comparable assets. This is a particular problem when valuing human capital, so even if comparables can be found, it is essential to factor in the time of the comparable transaction and the quality of the workforce. Also, the nature of the negotiation process, which satisfies some parties but not others, will dictate whether or not a particular transaction is published.

The income approach, applying discounted cash-flow methodologies allowing for time, risk and cost of money, takes the present value of the future income streams and future economic benefits that the workforce can create. This approach involves quantifying the future cash and/or profit flows and calculating the present values of those flows. Those future returns do not stop at the end of any given projected period, and so a terminal, or horizon value, needs to be calculated which is also discounted back to net present value. The discount rate to be applied to the cash-flows can be derived in a number of different models.
Of the three methodologies, the market approach has considerable difficulties because of the lack of information in the public domain involving the transfer of workforces. This approach could be useful, however in the valuation of small and select groups of staff with special skills such as corporate finance teams, or specialist technology or engineering teams.
The income approach is equally difficult in that it can be impossible to separate the financial benefit attributable solely and exclusively to the workforce.
The most commonly used methodology in valuing workforces is therefore the cost approach. This can be approached in two ways, as a percentage of the total package for each employee, or a group of employees as appropriate, or estimating the actual cost to recruit, hire, and train a replacement workforce. These costs will be considerable and will include salaries and benefits of employees involved in recruiting replacement employees, overhead costs, head-hunter recruitment fees, direct recruitment and hiring expenditure and the like.
Adjustments to the cost of creating that workforce may need to be made. Negative adjustments include where there are excess employees to the assembled workforce and so redundancy costs are to be borne, or where there is a high training cost. Positive adjustments include establishing a premium value to a proven team who have a consistent record of delivering measurable results together.
Such adjustments to value illustrate that directors can take positive steps to enhance the value of their human capital. Business culture and economic reality means that there is no job for life, and loyalty between employer and staff is less than it was. So if full value is to be realised, a workforce needs to be contractually bound to the company, with restrictive covenants, so the income they generate sticks with the company.
As human capital is highly mobile, a workforces’ knowledge is only for rent in the form of salaries. This is an asset, which is impossible to own in perpetuity. So managers and investors need to understand how to protect, manage, exploit and value this most moveable of assets.
In the last decade huge benefits have been exploited by large companies when they focus on actively managing and exploiting their know-how. Knowledge Management, and the value of Intellectual Capital, are now important tools and measurements of value, and stock markets recognise these hidden values by the simple fact that most quoted companies trade on a significant premium to their net tangible assets. So the markets are recognising that earnings depend on the know-how of a business, and that the physical assets are playing a less important role in terms of valuing a business. The same applies to smaller businesses.

Understanding and defining value for a workforce should not be just to support a fund-raising, IPO or sale price. It should also be an important measurement to drive investment decisions in the business, so that the management can track how shareholder value is being built and demonstrate to outside investors how the business strategy and investment in people will deliver investment returns.

After decades of a corporate culture in the UK of failing to invest in the training of staff and seeing it only as a cost, understanding the value of human capital and its investment returns should see a shift to nurturing what is now the most important asset of any business – its people.

William Baillieu is a director of Intellectual Property Management Ltd
E-mail: bb@ipmventures.co.uk

One Response »

  1. Hi. I like the way you write. Will you post some more articles?

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