Step-Up as the Value of Entrepreneurial Coordination

July 18, 2024 | by Marty Schmidt, Head of Valuation Services

In the third of a series about valuation topics (Intangible assets under the proposed Sec 48 regulations and Developer Mark-Ups), Leo Berwick’s Head of Valuation, Martin Schmidt, shares his views on the concept of Entrepreneurial Coordination and its ability to better describe the economics of the transaction better than Developer’s Profit. 

What is Entrepreneurial Coordination? 

As the development of solar, wind, BESS, and other energy transition-related projects continues to have the potential to be very profitable, proper characterization of the difference between the cost of a project and its Fair Market Value becomes ever more important in the calculation of the Investment Tax Credits. I believe that the concept of Entrepreneurial Coordination better captures the overall economics of a development project than the shorthand term Developer’s Profit. 

While easier to spell and pronounce, Developer’s Profit is an incomplete description of the value that is created through the coordinated efforts of the developer, the equipment suppliers, the contractors, and the investors. While the entrepreneur often takes on one or more of these roles, usually in concert with others, their main contribution to the success of the development project is the coordination of the efforts of all of these parties working toward a common purpose.   

In addition to coordinating the efforts of all of the parties, the entrepreneur has two other key roles: negotiating how the profits of the project get shared among the parties, each getting their deserved economic reward; and, the initial screening of project opportunities to identify those with the greatest potential to result in Fair Market Values in excess of cost. 

Expected Profitability vs. Achieved Profitability 

It is important to recognize the difference between the expected profitability of a development project and the achieved profitability. The former, an a priori estimate of the project’s profitability, is known as the Entrepreneurial Incentive. The achieved profitability of the development project, often informally referred to as the Step-Up, is a measure of the Fair Market Value of the project in excess of its cost. 

The entrepreneur implicitly uses the principle of Entrepreneurial Incentive to decide to proceed with a particular project rather than other potential projects that are available. Projects that do not appear to have the potential to achieve a sufficient value in excess of cost are often abandoned early to allow the entrepreneur to focus resources on projects with higher Entrepreneurial Incentives. Therefore, the projects that make it to completion are, to a large extent, a population that is skewed towards the most profitable opportunities.   

The well-known textbook The Appraisal of Real Estate 15th Edition, published by the Appraisal Institute, explains that a finished real estate product is created by combining land, labor, capital, and entrepreneurial coordination. It also observes that an entrepreneur will only undertake the construction of a project if they anticipate a profit in addition to the return of their equity investment. It defines the expected return as Entrepreneurial Incentive and the achieved return as Entrepreneurial Profit. This return is achieved through the investment of time and expertise of a number of parties and the execution of Entrepreneurial Coordination. 

It Takes a Village 

The potential profitability of the development of energy-transition projects represents returns for a wide variety of efforts and risks undertaken by the project team: technology risk; regulatory risk; construction risk; and market risk (to name a few). It also reflects potential benefits from several sources: market conditions; contract opportunities; targeted tax benefits and other incentives. 

As these development projects are not simple or failure-proof undertakings, they require the concerted effort of a number of different parties who share the risks and reap the benefits of the completed project. Defining the value in excess of cost as simply Developer’s Profit focuses on only one of the parties and leaves out some of the key activities that can make an energy-transition development project a success. The concept of Entrepreneurial Coordination focuses on the value of the assets without defining how the value was created or how it will be are shared.