Discounted risk is human capital risk

by Toby Elwin

Many firms admit they rely on the quality of entrepreneur to determine their funding decision, but rarely is this “quality” represented in a measurable, comparable assessment, or at least as measurable as weighted average cost of capital, discounted cash flow, capital asset pricing model, risk-adjusted rate of return, and other abstract financial models.

Human capital is the only asset that is not tangibly owned, however human capital risk is very tangible:

  • Compliance – Financial or reputational damage to the organization due to failures to meet legal or regulatory requirements;
  • Productivity – Loss of productivity or output due to under-skilled or under-motivated employees; or an organizational culture that does not encourage discretionary effort (the extra contribution over and above what is required to keep the boss off your back) from employees; and
  • Growth – Failing to maximize organizational capability or to identify and achieve internal or external opportunities for innovation or major growth or development of the business

Human capital risk is the most difficult risk your firm will manage.  You can’t simply throw money at human capital problems; though on the flip side, restricting money certainly impacts your human capital output.  The decision to invest comes down to a decision to invest in a team to deliver a project, on budget, and up to expectation:  this is a project.  Whether a venture capital investment, a merger, an acquisition, or any range of capital expenditure the risk is for the team to deliver and that is a human capital risk.

Real risk is human capital risk.  Without qualitative human capital inputs weighted average cost of capital, discounted cash flow, capital asset pricing models, risk-adjusted rate of return, and other “tangible” risk formulas are, at the least, incomplete or are a woefully inaccurate depiction of due diligence, risk, and expected rate of return.

But what is measurable?  Behavioral competencies and their frequency are measurable.  Cultural alignment is measurable.  Are either 100% accurate, no, but neither are any of the above financial models.  So if the “as if” financial pro forma lacks human capital risk, is this true due diligence?  If this is not complete or accurate how can a firm raise capital or seek, in good faith, investors based on glaring holes in their models?

The firm that has a human capital risk model identifies and builds mitigation strategies that offer higher market returns and higher investor rates of return.  Human capital risk models are a competitive and comparative advantage.  In my 15 years work in, multiple, post-merger environments that often turn into triage projects, human capital risk is the real risk to returns and is every bit as important at the valuation stage, front end, but rarely gets there in as serious a discussion as market, legal, and financial valuations.

People and firms can qualify and quantify human capital risk before investment and manage and mitigate human capital along the entire life cycle.  Those that do are market leaders and can better realize the return on human capital.

No doubt I got some things wrong, or left out some important ideas.  Please let me know what you think and suggestions you have for me to add value.

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  • http://www.TobyElwin.com Toby Elwin

    I’m working on the assumption that all managers want to maximize their employee potential. If that assumption (kind of like the assumptions economists make) Who would know their talent better? The direct manager or a human resources department?

    My assumption for these managers is similar to the assumption that managers know finance and budget development. Naive, no, just a base level standard I think managers could not function and succeed without – no matter private or public sector; for profit or not-for-profit. Each requires an ability to maximize resources.

    Thank you Dave, I enjoy your comments and contributions.

  • http://myflexiblepencil.com David M. Kasprzak

    Fantastic article. I very much appreciate your alignment of traditional financial metrics with human capital measurements. Well done.

    It is disheartening to see human capital concerns brushed off to some dark corner under the assumption that they can’t be measured easily when, clearly, there are measures for doing so. Even worse are those who believe that, somehow, through brute force and awkwardness managers can overcome human capital flaws.

    Would those same managers be able to overcome flawed business models that produce financial metrics indicative of major structural damage? Not without a great deal of expertise and engineering. So it is with the human capital infrastructure as well.

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