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. Human capital is often an unreported — but valuable — asset that can be difficult to appraise.

What is human capital?

Human capital comes in many forms. The most obvious example is employees on the company’s payroll. But 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 are typically the property of individual practitioners, not companies.

How is human capital valued?

Human capital generally isn’t reported on companies’ balance sheets under U.S. Generally Accepted Accounting Principles. However, most established businesses have developed this asset over the years.

A logical starting point for valuing an assembled workforce is to estimate the cost to reproduce or replace the company’s workers. This estimate includes the costs to recruit, hire and train each level of the company’s workforce. Valuators consider such items as headhunter fees; compensation expenses of recruitment and training staff; costs of background checks, drug tests and screening exams; and relocation fees, moving costs and signing bonuses.

When valuing workforce assets, an important distinction should be made between reproduction 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.

When are the income or market approaches used?

Although the cost approach is the most common way to value an assembled workforce, the income or market approaches are sometimes used to gauge whether the results of the cost approach make sense. For example, the value of a professional practice’s workforce under the cost approach 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 valuation professional might compute the value of a workforce under the cost approach as a percentage of the company’s total value and ask whether a buyer would be willing to pay a certain amount to acquire the assets or whether a seller would be willing to give up the assets for a certain amount.

Why do businesses need to value human capital?

There are several situations that call for human capital-related assets to be separately valued. In mergers and acquisitions, the value of human capital is relevant when establishing the selling price. An assembled workforce that’s been acquired is also an amortizable intangible asset for federal income tax purposes. Litigation involving alleged violations of contractual obligations — such as the terms of employment contracts, noncompetes or celebrity endorsement agreements — also may warrant damages calculations based on the value of human capital-related intangibles.

In addition, the value of an assembled workforce may be used to identify business goodwill in states that bifurcate business and personal goodwill when splitting up marital estates in divorce cases. Or it may be needed to lower a company’s property tax base, where intangibles are excluded from ad valorem property tax assessments.

Putting a price tag on people

In many industries, human capital is key to a successful business. A valuation professional can provide objective market data and financial analysis to help support a workforce appraisal. Contact us here if you have any questions.