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The agency problem is a conflict of interest inherent in any relationship where one party
is expected to act in another's best interests. In corporate finance, the agency problem
usually refers to a conflict of interest between a company's management and the
company's stockholders. The manager, acting as the agent for the shareholders,
or principals, is supposed to make decisions that will maximize shareholder wealth even
though it is in the manager’s best interest to maximize his own wealth.
While it is not possible to eliminate the agency problem completely, the manager can be
motivated to act in the shareholders' best interests through incentives such
as performance-based compensation, direct influence by shareholders, the threat of
firing and the threat of takeovers.
Principal-Agent Relationship
The agency problem does not exist without a relationship between a principal and an
agent. In this situation, the agent performs a task on behalf of the principal. This may
arise due to different skill levels, different employment positions or restrictions on
access.
For example, a principal will hire a plumber — the agent — to fix plumbing issues.
Although the plumber‘s best interest is to make as much income as he can, he is given
the responsibility to perform in whatever situation results in the most benefit to the
principal.
Incentives
The agency problem arises due to an issue with incentives. An agent may be motivated
to act in a manner that is not favourable for the principal if the agent is presented with an
incentive to act in this way. For example, in the plumbing example earlier, the plumber
may make three times as much money by recommending a service the agent does not
need. An incentive (three times the pay) is present, and this causes the agency problem
to arise.
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.
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.
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:
o Performance shares, where managers will receive a certain number
shares based on the company's performance
o 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.
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.