Understanding the Agency Problem
The agency problem arises when individuals entrusted with protecting the interests of others exploit their authority or power for personal gain.
This conflict is prevalent in various organizations, including businesses and governing bodies.
While organizations implement strict screening procedures, rewards for achievements, penalties for misconduct, and oversight mechanisms to address the issue, it is challenging to completely eradicate it due to the associated costs outweighing the benefits.
In finance, there are two main agency relationships:
- Managers versus Shareholders: A potential agency problem occurs between managers and shareholders when managers do not hold 100% of company ownership. Managers may make decisions not in the company’s best interests, such as expanding the business to enhance job security.
- Creditors versus Shareholders: Creditors assess a company’s risk, capital structure, and projected cash flows before lending money. However, these decisions are made under the authority of shareholders. An agency problem may arise between shareholders and creditors when shareholders act in their best interests.
Standard Methods to Address the Agency Problem
Threat of Takeover:
Major shareholders, particularly institutional investors like mutual funds, life insurance companies, and pension funds, can pressure management to deliver results.
They may use their voting power to remove underperforming management.
Additionally, the threat of a takeover from other companies seeking to improve the firm’s value through management, operational, or financial restructuring incentivizes management to act in the owners’ best interests by striving to enhance profits.
Agency Cost:
Shareholders bear agency costs to mitigate agency problems and maximize owner value.
Aligning management compensation with share price maximization is a common and cost-effective strategy.
This approach rewards managers for acting in the owners’ best interests.
One standard method is granting share options to managers, allowing them to purchase shares at a predetermined price.
If the share price increases in the future, the management’s compensation also increases.
Well-designed compensation packages help attract top managers, and tying executive remuneration to company performance encourages managers to align their actions with maximizing share price.