Potential Agency Problems
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, the two primary agency relationships that exist are between:
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, at times, may make decisions that have the potential to be in conflict with the best interests of the shareholders. For example, managers may grow their firm 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 the main concern of creditors.
  • Stockholders, however, have control of such decisions through the managers.
  • Since stockholders will make decisions based on their best interest, 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 Shareholder's Best Interest
Four primary mechanisms are used to motivate 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 have the ability to 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 even 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.

To learn more about governance, please see the article, Governance Pays.

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