This post is authored by Solange Charas, Ph.D. Dr. Charas is the president ofCharas Consulting, Inc., the Chief Human Capital Officer at Integral Board Group and an Adjunct Professor at NYU, M.S. in Human Resource Management and Development.
Intuitively we know that people create value, and business results are a function of a highly engaged workforce. But can the financial contribution of employees be quantified? And should it be used to predict financial returns? It can and it should! Despite your own highly effective way of doing due diligence, you’ve probably missed something—and likely, it’s because you don’t have the tools to monetarily value employee impact on future returns. Research has shown that a standard-deviation change in employee engagement can enhance EBITDA by 40%, and my experience, highlighted below, confirms the relationship between employee engagement and financial returns.
We Need a Paradigm Shift
The traditional approach of verifying headcount, compensation and benefits expense, albeit often ranging from 60% to 80% of gross revenue, is not enough to allow you to understand how people impact the organization—it’s like looking at a balance sheet and trying to fully understanding the business model. HBR research shows that more than 75% of transactions fail to meet their financial expectations, which indicates there may be something inherently flawed in the “traditional approach.”
Having successfully participated in over 50 transactions using my proprietary quantitative approach to valuing human capital, three trends emerge:
- Human-capital based information changes the valuation of the property;
- Quantitative analyses change post-acquisition management strategy;
- Small changes in employee productivity have an accretive impact on returns.
The exhibit below, taken from one of my projects, demonstrates how powerful human capital is in driving economic value creation. The left box reflects the expected deal outcomes, based on the traditional due diligence approach. The right box reflects actual performance and demonstrates the benefit of understanding the relationship between human capital and financial outcomes. For this project, a pre-acquisition due diligence focused on valuing HR impact identified that this was not a high-engagement organization and pinpointed several specific interventions subsequently implemented in 2012 that enhanced employee engagement, management effectiveness, organization design and HR programs. The cost of the due diligence and assessment, as well as the follow-on consulting (approximately $500,000 or 0.9% of total SGA expense) were more than offset by the resulting reduction in staff and improved productivity, reflected in a 58% increase over the original projected cumulative EBITDA. The average employee engagement scores improved from 2.9 to 3.3 over the three-year period.
The cumulative three-year differential shows an additional $37.3 million return or 58% improvement on the original projections for EBITDA and 147% improvement in estimated profit margin.
To break from the traditional approach, the following questions should be addressed in the due diligence process: Are employees fully engaged? Is the organization structured efficiently? Is management effective in both transformational and transactional influence? Do we have too many employees or too few to achieve business objectives? Are there too many, insufficient or poorly designed HR programs? My approach allows us to quantify the economic impact of the employees on future performance, which can then be integrated in the pro formas.
The three things you can do to enhance your understanding of the target investment property from an HR perspective are:
- Execute a more comprehensive HR due diligence. Dig under the numbers to understand what’s really going on in the target company. Ask the following questions: Do you have a low or a high engagement organization? How do the perceptions about the organization from management and the employees differ? Given the information, are your financial projects accurately predicting the future?
- Understand the human capital “health” of the organization. Does the organization need “fixing”? And if so, what needs to be done to enhance the company from a human capital perspective? Will additional investments generate a higher-than-expected return? Can the additional investment be used to offset the cost of the transaction—in other words, can future identified HR interventions be self-funded?
- Create a post-acquisition transition strategy before the deal closes. Research has shown that the most successful transactions are those where the going-forward strategy has already been developed.
A quantitative approach to understanding the impact of human capital can have significant impact on deal evaluation and pricing, and it should not be ignored. This approach can also be used to enhance the performance of existing portfolio companies, so you haven’t missed the boat.
Albert Einstein put it best: The definition of insanity is doing the same thing over and over and expecting a different result. Maybe it’s time to do something different.