Agency Relationships in Financial Management

An agency relationship arises when the principal hires an agent to perform some services or the decision-making authority is delegated to the agent. However, the agent is not fully responsible for the decision that is made. Since the agent and the principal may have different goals, the agency relationship creates a potential conflict of interest.

Within the financial management context, the primary agency relationships are those:

  • Between shareholders (the principal) and managers (the agent).
  • Between debt-holders (the principal) and managers (the agent).

Agency Problems: Stockholders vs Managers

A company's shareholders (the principal) delegate decision-making authority to the managers (the agent). Since the managers typically do not own 100% of the firm, they will neither gain all the benefits created nor bear all the costs and risks of their decisions.

Shareholders and managers have divergent goals. The Shareholders goal is to maximize shareholder value while the manager's goals is Job security, Power, status, and compensation etc.  Thus, managers may have the incentive to take actions that are not in the best interest of the shareholders. Because managers usually own only a small interest in most large corporations, potential agency conflicts are significant

Mechanisms Used to Motivate Managers to Act in Shareholders' Best Interest

Managerial compensation. The compensation package should be designed to meet two objectives: one is to attract and retain capable managers, two is to align managers' actions with the interest of shareholders.  Compensation should be linked to the managers' performance, typically through annual performance bonuses and long-term stock options. To motivate managers to focus on maximizing stock prices, companies often grant stocks to managers through:

• Performance shares:  Management receives a certain number of shares if the company achieves predefined performance benchmarks.

• Executive stock options:  Management is granted an option to buy stock at a stated price within a specified time period.

Direct intervention by shareholders:  The majority of stocks are owned by institutional investors, such as insurance companies, pension funds, and mutual funds.  Institutional investors can exercise considerable influence over most of the firm's operations.

The threat of firing:  Shareholders can nominate and elect the board of directors, who oversees the company. Through the board of directors, shareholders can oust management with poor performance.

The threat of takeovers: If a firm's stock is undervalued due to poor management, a competitor may acquire the firm even at the opposition of its management.  The acquirer can replace management with their.own management team.

Agency Problems: Shareholders (Through Managers) vs. Creditors

Managers are the agent of both shareholders and creditors.  Shareholders empower managers to manage the firm.  Creditors empower managers to use the loan.  Being employed by the firm, managers are more likely to act in the best  interest of shareholders, not creditors.

Through their managers/agents, shareholders may maximize their wealth at the expense of creditors by:

  • Taking riskier projects than those agreed to at the outset:  Creditors lend money to a firm based on its perceived business and financial risk. If shareholders take riskier investments, the shareholders receive the full benefit of success, but the creditors may share the losses in case of failure.
  • Borrowing more debt to significantly increase dividends or repurchase outstanding stock: The firm becomes riskier because of increased leverage.  Creditors are hurt because more debt ;will claim against the firm's cash flows and assets.

To protect themselves against shareholders, creditors often include restrictive covenants in debt agreements.  In the long-run, a firm that deals unfairly with creditors may impair the shareholders' interest because the firm may:

  • Lose access to the debt markets; or
  • Be saddled with high interest rates and restrictive covenants.

Thus, as agents of both shareholders and creditors, managers must treat the two classes of security holders fairly.