One of the challenges Mergers & Acquisitions advisors face is educating business owners about valuation. In an ideal world, owners would begin assessing the strengths and weaknesses of their companies years before they consider putting them up for sale. In this way they would come to a good understanding of what their businesses are worth to buyers and would already have a realistic idea of valuation and deal structure. Unfortunately, 90%+ owners procrastinate and inevitably are disappointed to discover their companies are not worth to buyers what they what they’ve estimated they’re worth.
Proper valuation of a company takes into account a number of things. Here we will talk about the difference between physical capital and intellectual capital and how they affect valuation.
What Is Physical Capital?
Physical capital is the physical property or tangible assets that the company owns. This would include the buildings or other real estate the company owns, machinery, tools, and equipment. These items can be sold directly, often depreciate over time or with use, and will be listed in financial statements as assets. It is relatively simple to estimate the value of physical capital, although it is advised to hire a certified appraiser of machinery and equipment at least 2-3 years prior to a sale, and then have the appraisal updated annually.
The asset method of valuation considers the value of a company’s physical capital.
What Is Intellectual Capital?
In comparison, intellectual capital is intangible and trickier to value. For most companies, intellectual capital comprises the larger share of value – perhaps up to 80% of valuation is dependent on things that cannot be held or sold directly. Intellectual capital is comprised of things the company’s management or employees contribute to its overall profitability like:
Knowledge
Talent
Skills
Abilities
These things cannot be touched, only experienced. This is often referred to as human capital. Examples of human capital would be a charismatic team leader, an effective salesman, or a wonderful organizer. They cannot easily be replaced because they excel at what they do. Buyers are very keen to know whether these kinds of people will remain with the company after a sale. If the owner is one of these people and is very necessary to the day-to-day running of the company, the business is owner dependent. This may significantly affect its valuation and marketability.
There are other types of intellectual capital in addition to human capital. Structural capital is critical to a business’s success. Structural capital refers to how the company has organized itself for both day-to-day operations and for replacing and training new workers. If a company has processes and procedures in place and its workers are well trained in those processes and procedures, changes and crises are much more easily weathered. It’s much simpler to bring on new people if the management knows exactly what the new employees have to know and how to teach it to them.
Structural capital also includes data the company has gathered in order to do its work, proprietary software, and intellectual property. These are often far more valuable than physical capital but much harder to value without considering their value to the market as a whole or to competitors.
Additionally, the company’s relationships with their customers and the public are also forms of capital. If a company has built up a strong brand and a broad and loyal customer base, these will both make it more valuable and much more attractive to buyers. They understand that the company’s reputation and relationships will help extend its profitability after a sale without a lot of input from them.
Intellectual and structural capital are valued using the market and income methods of valuation. These methods are based on cash flow and future growth projections. While it is important to understand that different buyers may place different value on certain items, cash flow is almost universally the arbiter of overall value and deal structure.
Physical Capital vs. Intellectual Capital
It’s not a competition between physical capital and intellectual capital in terms of importance. Both are important in their own ways. Some companies manage to be very profitable with almost no physical capital. Other companies have very valuable tool and machinery inventories that buyers are attracted to independent of their other assets. There are many different business models that work and can be profitable. What’s essential is to know what your company’s assets are well before you decide to put it on the market. Understanding what kinds of capital your business has and how that capital can be strengthened and leveraged for a sale is what a proactive business owner should do as part of any exit planning strategy.
