The challenge of convincing the agent to act in the principal’s best interests, rather than their own, is known as the agency problem.
What Is the Agency Problem?
Conflicts develop when those who have been given the responsibility (the agents) of protecting the interests of others (the principal) instead exploit the authority or power for their personal gain.
It is a widespread issue that affects almost every organization, including businesses and governing bodies. Organizations make efforts to address it by putting in place measures like strict screening procedures, rewards for achievements, penalties for bad conduct and watchdogs. However, no organization is able to completely address the issue because the costs of doing so eventually outweigh the value of the outcomes.
There are two main agency connections in finance:
Managers versus Shareholders
A possible agency problem between managers and shareholders emerges if the management holds less than 100% of the company’s share.
Managers may make choices that are not in the best interests of the company. For instance, managers may expand their businesses in an effort to boost their own job security.
Creditors vs Shareholders
Creditors evaluate a company’s risk, capital structure and projected capital structure before deciding whether to lend it money. The prospective cash flow of the business, which is the primary concern of creditors, is impacted by all of these factors.
However, such choices are made under the authority of shareholders.
There might be an agency issue between shareholders and creditors since shareholders will act in their own best interests. Managers could, for instance, borrow funds to repurchase shares in order to reduce the company’s share base and boost shareholder return. Even though shareholders will get benefit from this strategy, creditors will be worried due to the rise in debt that will impact future cash flows.
Common Methods Adopted to Avoid the Agency Problem
Threat to Take Over
Shareholders pay agency costs in order to reduce agency issues and help maximize owners’ value. The most common and cost-effective strategy is to align management remuneration with share-price maximization. The goal is to reward managers for working in the owners’ best interests. Giving managers share options is a common way to do this. Managers can buy a share at a predetermined market price; if the price of the share increases in the future, management remuneration will increase as well.
Furthermore, well-designed compensation packages enable businesses to hire the best managers out there. More businesses today tie executive remuneration to the company’s performance. By providing managers with a financial incentive to maximize shares, this incentive seems to encourage managers to behave in a way that is relatively compatible with maximizing share price.