What are Agency Costs
Agency costs are a type of internal cost that arises from, or must be paid to, an agent acting on behalf of a principal. These costs arise because of core problems, such as conflicts of interest, between shareholders and management. Shareholders wish for management to run the company in a way that increases shareholder value, while management may wish to grow the company in ways that maximize their personal power and wealth that may not be in the best interests of shareholders.
BREAKING DOWN Agency Costs
Based on a disagreement between management and shareholders as to what actions are in the best interest of the business, agency costs result. Agency costs include any expense that is associated with managing the relationship and resolving differing priorities. While shareholders are most concern with increasing share value, management may be more concerned with growing the business in ways that increase their personal wealth. Any changes in business activities that may lead to lower share prices are likely to be met with resistance by shareholders who maintain profit as a primary concern.
The conflict is based on the fundamental difference in the goals associated with the individuals on each side of the relationship, referred to as the principal-agent relationship. While the most common reference to the principal-agent relationship includes management as the agent and shareholders as the principal, other relationships contain similar characteristics, such as the relationship between politicians, functioning as the agent, and voters, functioning as the principal.
Also referred to as agency risk, agency costs are inevitable within an organization whenever the principals are not completely in charge; the costs can usually be best spent on providing proper material incentives, such as performance bonuses and stock options, and moral incentives for agents to properly execute their duties, thereby aligning the interests of principals and agents.
Shareholders who disagree with the direction management has selected may be less inclined to hold the company’s stock over the long-term. If a specific action encourages multiple shareholders to sell their shares, it could result in a drop in stock price for the company in question. Additionally, a large sell-off on the part of shareholders may raise concerns for other potential investors, further lowering the price.
In cases where the shareholders become particularly dissatisfied with the actions of the business, an attempt to elect different members to the board of directors may take place. Not only can this incur financial costs, but it can also result in the use of other resources, such as time, to complete the process.