Human Capital: What’s It Worth?

In today’s tight labor market, human capital is critical to the success of a business. The term “human capital” refers to a trained and assembled group of workers who know how to operate equipment, follow the company’s policies and procedures, innovate to build new products and services, and work together as a team to achieve the company’s strategic goals. Although it’s not usually reported on the balance sheet, human capital can be a valuable asset.

A need for Valuation

Investors, lenders and other stakeholders have been asking for more detailed information about human capital in recent years. Enhanced financial statement disclosures may call for valuations of various human-capital-related intangible assets. The fair value of human capital also comes into play when reporting business combinations and testing for impairment under U.S. Generally Accepted Accounting Principles.

The value of these assets may be relevant in other situations, too, including:

• Mergers and acquisitions,
• Ad valorem property tax assessments, and
• Divorce cases in jurisdictions that differentiate business goodwill from personal goodwill when splitting up marital estates.

In addition, litigation involving alleged violations of contractual obligations — such as the terms of employment contracts, noncompetes or celebrity endorsement agreements — may warrant damage calculations based on the value of human capital.

Beyond Employees

Human capital comes in many forms. The most obvious example is employees on the company’s payroll. It also may include relationships with independent contractors, consultants and celebrities, as well as employment contracts, noncompetes and confidentiality agreements.

Professional licenses may be considered another type of human capital, because they allow professional services firms to conduct business and, therefore, add value. But these licenses can’t be transferred to third parties and, therefore, are typically the property of individual practitioners, not the company.

Reproduction vs. Replacement

A logical starting point for valuing human capital is to estimate the cost to reproduce or replace the company’s workers. This estimate should include the costs to recruit, hire and train each level of the workforce.

Examples include headhunter fees, salaries and benefits of recruitment and training staff, relocation fees, moving costs, and signing bonuses. Valuators also may factor in the costs of background checks, drug tests and screening exams, as well as any lost productivity of new and existing staff during the recruitment and training processes.

When valuing human capital, an important distinction should be made between reproduction cost and replacement cost. Reproduction cost is the current cost of an identical property — in other words, the same number of employees with the same skills, education levels, experience and salary requirements.

Replacement cost is the current cost of employing a similar workforce that has the nearest equivalent utility to the existing workforce. Replacements might be younger employees who are willing to perform the work for less money — or fewer employees who are more highly qualified and efficient — than the existing workforce.

Additional Techniques

The income or market approaches are sometimes used to gauge whether the results of the replacement or reproduction cost analyses make sense. For example, the cost to reproduce or replace the company’s workers could be divided by the number of employees to calculate the average value per employee. This amount could then be compared to the average net realizable billable hours per employee to impute the firm’s return on human capital.

Assembled workforces aren’t normally sold as separate assets, so the market approach is rarely used to value human capital. But a valuator might ask: How much would a buyer be willing to pay to acquire such assets? And would a seller be willing to give up these assets for this amount?

Specialized Approach

Valuing human capital presents many challenges compared to standard business valuations. It’s important to hire an expert with an in-depth understanding of today’s human resource guidelines, employment trends and market compensation rates. Human capital should be valued using objective market data and independent analysis of the case at hand.