Why Human Capital Should be a Line Function

McDonald's Golden Arches

What is this logo worth? And how did it get to be so valuable?

Enterprise Value is the total unlevered value of the firm. For publicly traded companies, mathematically it is the market value of the stock plus the value of debt. If you subtract from enterprise value the market value of its tangible assets, what you have left is the market’s appraisal of the total value of the intangible assets. That is what has come to be called Intellectual Capital, and we abbreviate it as IC.


IC is further divided into three components: Human Capital, Structural Capital and Relational Capital.


– Human Capital comes and goes everyday, either up and down the elevator, or into and out of the parking lot.


– Structural Capital is all the stuff the Humans have to work with: processes, systems, databases, infrastructure, intellectual property, your Six Sigma program, your talent acquisition program, training programs, that sort of thing.


– Relational Capital is made up of your relationships with your customers, suppliers, and depending on your industry, perhaps government or regulators.


When we look at a company like Google, or Facebook, you can see quite easily that there was some person or persons that started it all, and the company grew from there. It is all about a person or group that had a vision or idea, and they hired and motivated other like-minded souls, and voilà, they became a force to be reckoned with.


It’s a bit harder to see this effect when you look at an established company, like McDonald’s. McDonald’s is by many standards a relatively young company. It was 1948 before the first hamburger was sold, and 1955 before Ray Kroc joined the company. It’s market cap as of today was $94.4 billion, and its enterprise value was $107.9 billion. The book value of its tangible assets comes to just $29.0 billion. That’s just 27% of enterprise value, leaving the other 73% to Intellectual Capital.


For fun, let’s compare that to Navistar, the old International Harvester. Their market cap was $1.45 billion today, their debt was $4.4 billion, bringing their EV to $5.86 billion. That compares to tangible assets of $10.5 billion. Navistar’s IC is a negative $4.64 billion. You can see that a lot of the investment in tangible assets has been wasted. It suggests a huge Human Capital, Structural Capital or Relational Capital problem. We don’t see the same thing at Deere or Cat, so we know its not the industry.


Back to McDonald’s, while this extra value isn’t all attributable to the company’s current workforce, it is all due to the company’s current and past workforce. Ray Kroc obviously gets credit for some part of that, but when you try to account for the fact that the company’s earnings and revenue have grown at 9% a year for the last three years, you have to believe that something has been institutionalized.


What we are looking at Human Capital that has been converted into Structural Capital and Relational Capital over the years. The company now has a way of doing things (Structural Capital), a brand (Structural Capital), and a brand cache with its customers (Relational Capital). It also has an awesome supply chain (Structural Capital) with its suppliers (Relational Capital), and impeccable quality control (Structural Capital) and marketing (Structural Capital). But it all began with the Humans at an earlier time that precedes the current employees tenor.


So here is the point: Human Resources – HR – is a staff function almost everywhere, and a backwater in many companies. Yet, arguably, it is the single most important driver of shareholder value. Why isn’t it a line function?


The argument I hear is that the performance of HR is too hard to measure. I disagree. My belief is that the performance of HR is measured over too short of period of time and based upon non-measurable criteria, much as the rest of corporate America measures most everything. If it didn’t occur this quarter or this year, it just doesn’t matter.


That is, we believe, misguided.


Companies love to promote and move people and not hold them accountable for their past decisions. I have argued in the past that banking is the poster child of this. They reward salesmen based upon their loan production in the last quarter or year, while the performance cycle should be over the business cycle. By the time the economy turns down, many of these ‘top’ salesmen are in different jobs or functions and not accountable for their decisions.


This should be changed. Compensation should match the period over which real performance is measurable.


It takes at least two years for someone to grow into their job. And long after that the decisions that HR makes effects their motivation and performance. Things like training.


HR’s job is to get the best people possible into the value-creating jobs. They are also responsible for the training, measurement, compensation, perks and all else that goes into rewarding employees for good work.


Large companies need to start to focus on the HR function and bring it into the line as a real partner. Smaller companies will find that they need to outsource certain skills. But still, the buck stops at the top.


And speaking of the top, smaller companies commonly suffer from what has been called a “key man issue”. A key man issue is simply a failure to hire and train a successor, whether due to an absence of scale or inclination. Its presence is a huge deduction from the enterprise value of the company. If a business owner wants to really maximize the value of his company, he has to prepare for his own departure, whether through sale, death or other means. He has to define what his company’s secret sauce is, what its seven secret ingredients are, and ensure they survive his passing. That is, if he values his wealth.


Resistance to HR being a line function will be felt from all sides. HR people will not want to feel the heat of the kitchen. If so, they aren’t the heat resistant type and will need to be replaced. Managers won’t want to relinquish control of hiring and compensation decisions. I would suggest that they either have the wrong person in HR or the manager needs to become his own HR person. The later is the logical decision in a smaller company, with outsourced HR as a resource.


In the Knowledge Era, Human Resources should be made a line function, staffed with very talented people that take on the responsibility for the company’s future. The senior HR person should report directly to the President, and no one else. Together, they should be the two most important people at the board meeting.


How important is Human Capital? Important enough that Goldman Sachs no longer has an HR department. It’s the Human Capital department, as is ours.

To learn more, contact us

by Charles Smith

Mr. Smith is the founder of Pegasus Intellectual Capital Solutions, a boutique investment bank specializing in mergers and acquisitions, Capital Raising and restructuring and workouts. The firm is an innovator in the use of Intellectual Capital Audit for pre-closing due diligence and in turnarounds. Charles can be reached at csmith@pegasusics.com