An agency relationship occurs when a principal hires an agent to perform some duty. A conflict, known as an "agency problem," arises when there is a conflict of interest between the needs of the principal and the needs of the agent.

In finance, there are two primary agency relationships:

  • Managers and stockholders
  • Managers and creditors

1. Stockholders versus Managers

  • If the manager owns less than 100% of the firm's common stock, a potential agency problem between mangers and stockholders exists.
  • Managers may make decisions that conflict with the best interests of the shareholders. For example, managers may grow their firms to escape a takeover attempt to increase their own job security. However, a takeover may be in the shareholders' best interest.

2. Stockholders versus Creditors

  • Creditors decide to loan money to a corporation based on the riskiness of the company, its capital structure and its potential capital structure. All of these factors will affect the company's potential cash flow, which is a creditors' main concern.
  • Stockholders, however, have control of such decisions through the managers.
  • Since stockholders will make decisions based on their best interests, a potential agency problem exists between the stockholders and creditors. For example, managers could borrow money to repurchase shares to lower the corporation's share base and increase shareholder return. Stockholders will benefit; however, creditors will be concerned given the increase in debt that would affect future cash flows.

Motivating Managers to Act in Shareholders' Best Interests

There are four primary mechanisms for motivating managers to act in stockholders' best interests:

  • Managerial compensation
  • Direct intervention by stockholders
  • Threat of firing
  • Threat of takeovers

1. Managerial Compensation
Managerial compensation should be constructed not only to retain competent managers, but to align managers' interests with those of stockholders as much as possible.

  • This is typically done with an annual salary plus performance bonuses and company shares.
  • Company shares are typically distributed to managers either as:
    • Performance shares, where managers will receive a certain number shares based on the company's performance
    • Executive stock options, which allow the manager to purchase shares at a future date and price. With the use of stock options, managers are aligned closer to the interest of the stockholders as they themselves will be stockholders.

2. Direct Intervention by Stockholders
Today, the majority of a company's stock is owned by large institutional investors, such as mutual funds and pensions. As such, these large institutional stockholders can exert influence on mangers and, as a result, the firm's operations.


3. Threat of Firing
If stockholders are unhappy with current management, they can encourage the existing board of directors to change the existing management, or stockholders may re-elect a new board of directors that will accomplish the task.

4. Threat of Takeovers
If a stock price deteriorates because of management's inability to run the company effectively, competitors or stockholders may take a controlling interest in the company and bring in their own managers.

In the next section, we'll examine the financial institutions and financial markets that help companies finance their operations.




Types Of Financial Institutions And Their Roles

Related Articles
  1. Investing

    How Dividends Affect Stockholders' Equity

    Find out how dividends affect a company's stockholders' equity and how the accounting process changes based on the type of dividend issued.
  2. Investing

    Stock Rights Issue

    Rights are offers that allow existing stockholders to buy additional shares at a predetermined price, for a set time period. Usually, the number of shares the investor can purchase are in proportion ...
  3. Investing

    Who is a Shareholder?

    A shareholder is a person, company or other entity that owns at least one share of a company’s stock.
  4. Investing

    How Corporate Events Affect Stock- And Bondholders

    Investors tend to buy either stocks or bonds, but rarely choose between the two. Find out when you'll benefit from one over the other.
  5. Investing

    Why Do Companies Care About Their Stock Prices?

    Read on to learn more about the nature of stocks and the true meaning of ownership.
  6. Managing Wealth

    What is Convertible Preferred Stock?

    Convertible preferred stock is preferred stock that can be converted into common stock as of a predetermined date at a specified ratio.
  7. Investing

    Chevron Stock: Capital Structure Analysis (CVX)

    Learn the nuances of multiple metrics that measure a firm's equity and debt capitalization, while determining Chevron's own capital structure.
  8. Managing Wealth

    Knowing Your Rights As A Shareholder

    Common shareholders typically enjoy six main rights.
  9. Managing Wealth

    Keeping Control of Your Business After the IPO

    Taking a company public doesn't mean founders must completely give up calling the shots. Before the IPO, consider these tactics to keep control after it.
  10. Investing

    The 4 Key Elements Of A Well-Managed Portfolio

    If you choose an actively managed portfolio, be sure that your manager isn't neglecting one of these four points.
Frequently Asked Questions
  1. What are Common Examples of Monopolistic Markets?

    Discover what causes real instances of market monopoly, how it persists and where monopoly privilege is most common in the ...
  2. What is the gold standard?

    The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold, but ...
  3. What's the most expensive stock of all time?

    The most expensive publicly traded stock of all time is Warren Buffett’s Berkshire Hathaway.
  4. What is a "socially responsible" mutual fund?

    As the name suggests, socially responsible mutual funds invest exclusively in socially responsible investments.
Trading Center