- Search Search Please fill out this field.
What Is an Agency Problem?
Understanding agency problems.
- How to Minimize Risks
- Real-World Example
- Agency Problem FAQs
- Corporate Finance
- Corporate Finance Basics
Agency Problem: Definition, Examples, and Ways To Minimize Risks
James Chen, CMT is an expert trader, investment adviser, and global market strategist.
Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.
Investopedia / Lara Antal
An 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 , an 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 their own wealth.
- An agency problem is a conflict of interest inherent in any relationship where one party is expected to act in the best interest of another.
- Agency problems arise when incentives or motivations present themselves to an agent to not act in the full best interest of a principal.
- Through regulations or by incentivizing an agent to act in accordance with the principal's best interests, agency problems can be reduced.
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. Agents are commonly engaged by principals due to different skill levels, different employment positions, or restrictions on time and access. For example, a principal will hire a plumber—the agent—to fix plumbing issues. Although the plumber‘s best interest is to collect as much income as possible, they are given the responsibility to perform in whatever situation results in the most benefit to the principal.
The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way. For example, in the plumbing example, 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, causing the agency problem to arise.
Agency problems are common in fiduciary relationships, such as between trustees and beneficiaries; board members and shareholders; and lawyers and clients. A fiduciary is an agent that acts in the principal's or client's best interest. These relationships can be stringent in a legal sense, as is the case in the relationship between lawyers and their clients due to the U.S. Supreme Court's assertion that an attorney must act in complete fairness, loyalty, and fidelity to their clients.
Minimizing Risks Associated With the Agency Problem
Agency costs are a type of internal cost that a principal may incur as a result of the agency problem. They include the costs of any inefficiencies that may arise from employing an agent to take on a task, along with the costs associated with managing the principal-agent relationship and resolving differing priorities. While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk of agency costs.
Principal-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings. The Fiduciary Rule is an example of an attempt to regulate the arising agency problem in the relationship between financial advisors and their clients. The term fiduciary in the investment advisory world means that financial and retirement advisors are to act in the best interests of their clients. In other words, advisors are to put their clients' interests above their own. The goal is to protect investors from advisors who are concealing any potential conflict of interest.
For example, an advisor might have several investment funds that are available to offer a client, but instead only offers the ones that pay the advisor a commission for the sale. The conflict of interest is an agency problem whereby the financial incentive offered by the investment fund prevents the advisor from working on behalf of the client's best interest.
The agency problem may also be minimized by incentivizing an agent to act in better accordance with the principal's best interests. For example, a 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, or the threat of takeovers .
Principals who are shareholders can also tie CEO compensation directly to stock price performance. If a CEO was worried that a potential takeover would result in being fired, the CEO might try to prevent the takeover, which would be an agency problem. However, if the CEO was compensated based on stock price performance, the CEO would be incentivized to complete the takeover. Stock prices of the target companies typically rise as a result of an acquisition. Through proper incentives, both the shareholders' and the CEO's interests would be aligned and benefit from the rise in stock price.
Principals can also alter the structure of an agent's compensation. If, for example, an agent is paid not on an hourly basis but by the completion of a project, there is less incentive to not act in the principal’s best interest. In addition, performance feedback and independent evaluations hold the agent accountable for their decisions.
Real-World Example of an Agency Problem
In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to make the company appear to have more money than what was actually earned. The company's executives used fraudulent accounting methods to hide debt in Enron's subsidiaries and overstate revenue. These falsifications allowed the company’s stock price to increase during a time when executives were selling portions of their stock holdings.
In the four years leading up to Enron's bankruptcy filing, shareholders lost an estimated $74 billion in value. Enron became the largest U.S. bankruptcy at that time with its $63 billion in assets. Although Enron's management had the responsibility to care for the shareholder’s best interests, the agency problem resulted in management acting in their own best interest.
What Causes an Agency Problem?
Agency problems arise during a relationship between a principal and an agent. Agents are commonly engaged by principals due to different skill levels, different employment positions, or restrictions on time and access. The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way.
What Is an Example of Agency Problem?
In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to make the company appear to have more money than what was actually earned. These falsifications allowed the company’s stock price to increase during a time when executives were selling portions of their stock holdings. When Enron declared bankruptcy, it was the largest U.S. bankruptcy at that time. Although Enron's management had the responsibility to care for the shareholder’s best interests, the agency problem resulted in management acting in their own best interest.
How to Mitigate Agency Problems?
While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk, known as agency cost, associated with it. Principal-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings. Another method is to incentivize an agent to act in better accordance with the principal's best interests. For example, if an agent is paid not on an hourly basis but by the completion of a project, there is less incentive to not act in the principal’s best interest.
American Bar Association. " ABA Model Code of Professional Responsibility ," Page 49. Accessed Sept. 19, 2021.
U.S. Securities and Exchange Commission. " Regulation Best Interest: The Broker-Dealer Standard of Conduct ," Pages 4-5. Accessed Sept. 19, 2021.
Federal Bureau of Investigation, Archives. " A Look Back at the Enron Case ." Accessed Sept. 19, 2021.
U.S. Securities and Exchange Commission. " SEC v. Andrew S. Fastow ." Accessed Sept. 19, 2021.
National Library of Medicine National Institutes of Health. " Steps to Strengthen Ethics in Organizations: Research Findings, Ethics Placebos, and What Works ." Accessed Sept. 19, 2021.
Laws & Regulations
Government & Policy
Finding a Financial Advisor
- Editorial Policy
- Do Not Sell My Personal Information
By clicking “Accept All Cookies”, you agree to the storing of cookies on your device to enhance site navigation, analyze site usage, and assist in our marketing efforts.
- Manage Employees
- Time Tracking
- Payroll Calculator
- Invoice Generator
- Terms and Condition
Solving the Agency Problem: How can we reduce agency problem?
- Post author: SYED
- Post published: January 30, 2019
- Post category: Financial Management
- Post comments: 0 Comments
It is important for organizations to address the agency problem in order to ensure effective management and decision-making. The agency problem is a conflict of interests between the principal and the agent, where the agent is expected to act in the best interest of the principal but may act in their own interest instead. It is a common problem in business organizations and can have serious repercussions if it is not addressed properly. In this article, we will discuss the different types of agency problem, the causes of agency problem, and the strategies that can be used to reduce agency problem.
Introduction to Agency Problem
Agency problem is the conflict of interests between the principal and the agent, where the agent may not act in the best interest of the principal. This problem is quite common in organizations and can have serious repercussions if it is not addressed properly. The principal is the party which delegates the authority to the agent to act on their behalf. The agent is the party which is delegated the authority to act on behalf of the principal. The principal is usually the owner of a business or a shareholder in the company, while the agent is usually the manager or executive of the organization.
The essence of the agency problem is that since the agent is not the owner of the business, they may not have the same incentives as the principal. This can lead to the agent acting in their own interest instead of the interest of the principal. This can have serious repercussions for the organization as it can lead to mismanagement, poor decision-making, and loss of value. Therefore, it is important for organizations to address the agency problem in order to ensure effective management and decision-making.
Different Types of Agency Problem
The agency problem can be classified into three main types. The first type is the principal-agent conflict, which is the conflict of interests between the principal and the agent. This is the most common type of agency problem and can have serious repercussions if it is not addressed properly. The second type is the principal-principal conflict, which is the conflict of interests between two principals, such as between the owners of a business. The third type is the agent-agent conflict, which is the conflict of interests between two agents, such as between two managers in a business.
Causes of Agency Problem
There are several causes of agency problem which can lead to the conflict of interests between the principal and the agent. The first cause is the lack of communication between the principal and the agent. If the principal does not communicate their expectations and goals to the agent, the agent may not act in the best interest of the principal. The second cause is the lack of trust between the principal and the agent. If the principal does not trust the agent, they may not be willing to delegate authority to the agent, which can lead to the agent not acting in the best interest of the principal.
The third cause is the lack of incentives for the agent. If the agent does not have the right incentives, they may not be motivated to act in the best interest of the principal. The fourth cause is the lack of performance evaluation and performance measurement. If the principal does not evaluate the performance of the agent, they may not be able to identify and address any conflicts of interests between the principal and the agent.
Strategies to Reduce Agency Problem
Fortunately, there are several strategies that organizations can use to reduce the Agency Problem and ensure better alignment between the principal and the agent. These strategies include performance evaluation and performance measurement, risk and reward sharing, corporate governance and internal control, communication and conflict resolution, and aligning the interests of the principal and the agent.
Performance Evaluation and Performance Measurement
Performance evaluation and performance measurement are key strategies for reducing the Agency Problem. Organizations should use performance metrics to measure the performance of the agent and ensure that they are acting in the best interests of the principal. Performance metrics should be tailored to the specific needs of the organization and should be regularly monitored to ensure that the agent is performing as expected.
Risk and Reward Sharing
Risk and reward sharing is another important strategy for reducing the Agency Problem. Organizations should ensure that the agent is adequately rewarded for their efforts and that they are taking on an appropriate level of risk. This will ensure that the agent is motivated to act in the best interests of the principal. Additionally, organizations should ensure that the rewards are commensurate with the risk taken by the agent.
Corporate Governance and Internal Control
Corporate governance and internal control are also important strategies for reducing the Agency Problem. Organizations should ensure that appropriate procedures and controls are in place to ensure that the agent is acting in the best interests of the principal. This can include measures such as regular reporting and monitoring, internal audit processes, and internal control systems. Additionally, organizations should ensure that their corporate governance processes are aligned with the interests of the principal.
Communication and Conflict Resolution
Communication and conflict resolution are also important strategies for reducing the Agency Problem. Organizations should ensure that there is effective communication between the principal and the agent and that any conflicts are resolved in a timely manner. This will ensure that the interests of the principal and the agent are aligned and that the agent is acting in the best interests of the principal.
Performance based incentive plans:
Most publicly traded firms now employ performance shares, which are shares of stock given to executives no the basis of performance as defined by financial measures such as earnings per share, return on assets, return on equity, and stock price changes.
If corporate acting is above the performance targets, the firm’s managers win more shares. If performance is under the target, however, they accept less than 100 percent of the shares. Incentive-based compensation plans, such as performance shares, are designed to satisfy two objectives.
First, they offer executives incentives to take actions that will prolong shareholder wealth. Second, these plans help companies attract and retain managers who have the confidence to risk their financial future on their own abilities- which should lead to better performance.
Direct intervention by institutional investors:
An increasing percentage of common stock in the corporate sector is owned by institutional investors such as insurance companies, pension funds, and mutual funds. The institutional money managers have the clout, if they choose, to exert considerable influence over a firm’s operation.
Institutional investors can impact a firm’s managers in two initial ways. First, they can meet with a firm’s management and offer a suggestion regarding the firm’s operations.
Second, institutional shareholders can sponsor an offer to be voted on at the annual stockholders’ meeting. Even if the proposal is opposed by management. Although such a shareholder-sponsored proposal is nonbinding and involves issues outside day-to-day operations. The results of these votes clearly influence management options.
The threat of takeover:
A hostile takeover, which occurs when management does not wish to sell the firm, is most likely to develop when a firm’s stock is undervalued relative to its potential because of inadequate management.
In a hostile takeover, the senior managers of the acquired firm are typically sacked. And those who are retained lose the independence they had prior to the acquisition. The threat of a hostile takeover disciplines managerial behavior and induces managers to attempt to maximize shareholder value.
Strategies to Align the Interests of Principals and Agents
Finally, organizations should use strategies to align the interests of the principal and the agent. This can include measures such as incentive structures, bonus systems, and performance-based compensation. Additionally, organizations should ensure that the incentive structures and bonus systems are designed to ensure that the agent is motivated to act in the best interests of the principal.
In conclusion, agency problem is a conflict of interests between the principal and the agent, which can have serious repercussions for the organization if it is not addressed properly. The causes of agency problem can include lack of communication, lack of trust, lack of incentives, and lack of performance evaluation and performance measurement. There are several strategies that organizations can use to reduce agency problem, such as aligning the interests of the principal and the agent, ensuring effective performance evaluation and performance measurement, ensuring risk and reward sharing, ensuring effective corporate governance and internal control, and ensuring effective communication and conflict resolution.
It is important for organizations to address the agency problem in order to ensure effective management and decision-making. By following the strategies discussed in this article, organizations can reduce the agency problem and ensure that the interests of the principal and the agent are aligned.
The Complete Finance Manager Course
Please Share This Share this content
- Opens in a new window
You Might Also Like
What are the types of agency cost
What are the main functions of financial management or, manager?
Define corporate social responsibility
Leave a reply cancel reply.
Please enter an answer in digits: 2 × three =
MBA Knowledge Base
Business • Management • Technology
Home » Financial Management » Ways of Resolving Agency Problems and Costs
Ways of Resolving Agency Problems and Costs
Agency problems are defined as problems happening due to conflicts of interests between a principal and an agent . An agent is hired by a principal and is supposed to perform on behalf of the principal with the aim of maximizing the principal’s benefits. However, the agent also has his own interests, and, during the time working for the principal, he may diverge from the ultimate purpose of working for the principal and may perform for his own benefit. In the financial field, there are two primary types of agency problems: between shareholders and managers, and between equityholders and debtholders.
First one is the agency problem between shareholders and managers . When a company is set up, the founder is the owner and manager. He will act on behalf of himself to create more wealth. If the owner sells a part of his ownership to outsiders, the owner-manager will not possess 100% of the company and a conflict of interests occurs. The insider manager/owner will not behave in a way that maximizes the company’s wealth and will have a tendency to take advantage, consuming for his personal desire at company’s expense. The less company stocks the managers own, the more likely conflicts of interests will occur.
The solution to the shareholders-managers agency problem is aligning the interests of managers with those of the shareholders, forcing them to work in a way that maximizes shareholders wealth . The incentive compensation is used to encourage managers, for governance structure to monitor them, or for leverage to constrain them. To execute the solutions, costs occur, and they are called agency costs. There are three main types of agency costs: costs occurring due to applying methods to monitor managers’ actions such as fees for using independent auditors; costs arising due to setting up the company’s organization in order to limit the managers from diverging shareholders’ interests; and opportunity costs that happen when shareholders take time to get a consensus before letting managers take action.
Next is the agency problem between equityholders and debtholders. The debtholders give loans to the firm and get returns from firm’s cash flow in the form of interest payments. The interest rate applied for each loan is calculated based on the existing risk level of the firm at the time the loan is issued. After receiving the loan, the stockholders take action through their management in the company and change the risk level, such as selling some assets and investing in risky projects. The debt value decreases because more debt risk is borne. In case the risky project is successful, debtholders will not receive more returns because their income is fixed. However, if that project fails, debtholders have to share the risks. In this case, the interests of the two parties are not aligned. In order to protect their benefits, the debt-holders will apply some mechanisms such as stricter covenants or rising interest rates. This causes the company difficulty in accessing the financial market and the debt costs increase. This creates agency costs. To alleviate agency cost from debts, equityholders and debtholders benefits should be balanced; experts suggest the use of incentive compensation and convertibles in a company’s leverage.
Nowadays, with the evolution of the business world, many new agency problems occur. Other types of agency problems such as conflicts of interests between shareholders who are executing company control and shareholders who are not, or minority shareholders. This happens when controlling shareholders who usually own a substantial portion of a firm’s ownership make decisions that are not beneficial for minority shareholders who do not have enough power to affect the decisions with voting rights. Over-investment problems happen when there are surplus free cash flows and managers investing in projects that are not value-added without facing financial constraints. Under-investment problems arise when a company acquires too many debts, and the risk of default makes managers reluctant to invest and analyze thoroughly before deciding. Sometimes these managers ignore risky but high return projects and choose investments in safe projects without good returns. There is another type of agency cost, which arises from using money to pay dividends and not investing in positive Net Present Value (NPV) projects.
In general, agency problems are related to the structure of ownership. The problems occur when the owners do not totally operate their businesses by themselves and when the owners acquire debts to finance the business. In other words, the benefit sharing among parties make people think and act more for themselves and lead to conflicts of interests. The shareholders and the managers, the majority shareholders and minority shareholders, the equityholders and the debtholders all invest in businesses, perhaps in different forms, and want their returns. However, with the participation of many parties, no one will be able to get all of the returns.
Each agency problem has its own core causes. Each mitigation mechanism also has its strengths and weaknesses . Thus, in order to deal effectively with a specific agency problem, we have to analyze the causes of the problem and choose the most suitable approaches to deal with it. In order words, we have to know what agency problems we are facing and why they occur.
There are many approaches (internal and external) for curbing agency problems in organizations. We will concentrate on internal mechanisms that companies can choose actively by themselves. They are compensation structure, corporate governance, and capital structure.
1. Compensation Structure
The conflicts of interest between managers and shareholders cause agency costs. Shareholders put money into a company, and they want their wealth maximized. Managers are hired to manage the company’s day-to-day activities. They invest their human capital in the company, and they want to maximize their investments as well. If the interests of the managers are attached to those of the shareholders, this divergence is solved. Stemming from this approach, companies offer incentive compensation to executives as a way of encouraging them to act in value-added ways to shareholders . Thus, in the executives incomes, besides basic salaries and quarterly bonuses, there are some incentive payments tied to their company’s performance in order to encourage executives to pay more attention to long-term performances. There are two popular types of incentive compensation: stock ownership and stock-option grant.
When the managers join the company, they are given a certain amount of stocks with preferred pricing or other ways to connect their interests with their company’s interests. While stock ownership gives managers the feeling of keeping real wealth, the stock-option grant gives executives opportunities to purchase a certain amount of their company’s stock at a predetermined price for a specific range of time in the future. Managers will own the stocks if they execute their rights, or their options will expire. The logic of these incentives is that managers will try their best to increase the company’s stock price because they can get more returns. This behavior benefits shareholders as well.
It is easy to understand that even though managers’ benefits are tied to those of the company, if the current stock price is higher than their predetermined price, it is a more attractive situation for managers. However, in the case of out-of-the-money options, the current stock price is lower than the predetermined price. The reasoning for setting up the option price in this way is wise because it forces executives to do their best to push their company’s performance, increasing stock price so that they gain when they exercise their options. However, the way the option price is set up also has negative outcomes. In order to gain from their options, managers will do everything to enhance the stock price, including manipulating the performance data. This destroys the effect of the mechanism. Furthermore, the stock market responds negatively to such information about financial data restatement . This gives executives constraints, and these constraints are even stronger when they have stockownership.
The question of what types of agency problems that incentive compensation will mitigate arises. The compensation mechanism works effectively with large agency problems such as choosing strategy and investment projects. Small agency problems such as perquisite consumption will be solved more effectively with direct monitoring. Furthermore, there is an interesting finding about compensation policy. If increasing incentive compensation is used to alleviate the agency problem of equity, decreasing the compensation is applied to mitigate the conflicts of interests between shareholders and bondholders. When the incentive compensation works well, managers will act according to shareholders benefits and choose investment policies that maximize shareholders wealth at debtholders expense. This hurts debtholders, and it makes the conflicts more severe. In this case, reducing the compensation for managers is a solution.
2. Corporate Governance
Corporate governance is also a mechanism used to deal with agency problems. Managers are hired to operate the company; in order to prevent them from deviation, one solution is to monitor them: look at their activities so that shareholders can stop any improper decisions before they become worse. Governance is mostly exercised by the board of directors who control executives based on the company’s rules and regulations. Usually board members are also firm executives. People debate that if executives can control themselves, then shareholders do not need to establish supervisory boards. Then outside directors, representatives of large shareholders, institutional shareholders, mutual funds, and even the state are nominated for boards of directors with the expectation of increasing supervisory effectiveness.
To enhance the monitor role of the board of directors and to separate the power of executives and board members, outside directors’ appointments become an inevitable trend. At first, outside directors execute their jobs to maintain their reputations in the field. Later on, to attract capable directors and to stimulate them, companies start offering stock-based incentive compensation . The compensation plans for directors work well in mitigating agency problems.
However, there is also a question about whether these incentive compensations really encourage directors to work on behalf of shareholders’ interests or to protect their incomes rather than their reputations. There are reasons for this skepticism. Agency problems appear in the same way as with executives compensation packages. To protect their benefits, directors tend to depend on managers and to compromise in making financial reports . However, boards that are less dependent on executives seem to perform worse than boards that are more dependent on company executives. The research infers that there may be agency costs arising from setting up a board of directors, but the benefits in reducing agency problems outweigh the costs.
The question arises of which agency problems will be solved effectively with the governance structure. Corporate governance is effective when agency risk is high; the company has surplus free cash flow. Direct monitoring is effective for small agency issues such as perquisite consumption. It is inferred that the direct intervention of directors will effectively impede managers from using cash resources in unproductive ways such as investing in projects or activities that do not generate value for shareholders but bring benefits for themselves. If the boards work effectively, a generous donation, an unnecessary overseas meeting, or purchasing a private airplane cannot occur. More mature companies with few investment opportunities may have excessive free cash flows; these cash resources may trigger unproductive investment or perquisite consumption.
3. Capital Structure
The roots of agency problems are the imperfect alignment of the principals and agents interests. Managers do not only work for the company’s benefit but also for themselves. These personal benefits include consuming excessive perquisites such as luxurious vacations, overseas conferences, or investing in projects that are risky and do not enhance the value of the shareholders. The existence of surplus cash flow is the condition that entitles managers to make unproductive investments. Thus, to impede the managers from acting in a way that is not value-added, surplus free cash flow should be reduced. Therefore, the question arises of how to lessen the amount of cash available within a company and simultaneously encourage managers to work more value-added. The answer is using leverage. In order words, the firm should change its capital structure and increase the debt/equity ratio .
Greater financial leverage can help reduce the agency costs by impacting managers including threat of liquidation, and the pressure of making money to pay for debt interests and principals. Leverage also helps reduce the conflicts between shareholders and managers in many ways, including choosing projects to invest and payout policy. However, the relationship between leverage and agency cost is not exactly negative. When the firm uses too much debt, the increase in cost of financial distress means that bankruptcy will be bigger than the decrease in the cost from the shareholders-managers conflicts.
When the company uses debts, it has to pay for the interest and principal; the higher the debts, the greater the payment. To make more money to pay these debts puts stress on managers. If the company fails to make enough money to pay for its interest expenses and debt principal on the due dates, the company may come to default. If this happens, the managers will lose their jobs, their incomes, their perquisites, and their reputations. Thus, to protect their benefits, managers will act in a way that keeps the company alive, healthy, and prosperous. This is what the stockholders want.
One type of agency cost is the cost of over-investment. In a firm that is not levered and has excessive cash flow after investing in positive NPV projects, the surplus cash is usually over-invested in cash or real assets rather than delivered to shareholders. Furthermore, it is possible for managers to put money in projects that are not thoroughly analyzed or even risky because there are excess liquid funds; managers do not have constraints about financial funds. These investments may not create value for shareholders. When leverage is applied, debts such as long-term loans are issued, and cash guaranteed for loan and interest payments consume significant parts of surplus cash, thereby reducing the free cash flow under the manager’s discretion. So, debts play an important role in reducing the over-investment problem.
Other ways to reduce the available cash and reduce opportunities for managers to waste the company’s resources is a payout policy-share repurchase and dividend payout. When the company has excessive cash, the possibility of using it in unproductive ways by controlling managers is high. Cash extraction helps align interests between managers and shareholders, but payment is for creditors. There are other ways to make shareholders more pleased including paying money directly to them by applying a payout policy. This form of cash extraction is proven to alleviate agency problems, especially for companies that are mature, have massive surplus cash, and lack investment opportunities.
There is no obligation for managers to distribute the surplus cash to shareholders; therefore, the question arises of how to make them do this. If the company has surplus cash and investment opportunities are not plentiful, better managerial incentive alignment and closer monitoring by external shareholders are important factors stimulating such payout.
The use of leverage has two sides. It can reduce agency problems such as over-investment due to surplus cash, but when too much debt is used the conflicts of interest between the equity holders and debt holders become serious and lead to the problem of under-investment. Decreasing the incentive compensation will be the best choice to mitigate the conflicts of interests between shareholders and bondholders.
Mechanisms for dealing with agency problems are multifunctional. Each method mentioned above not only works effectively alone, but companies can substitute these mechanisms. In order to alleviate the agency problems coming from surplus free cash flow, debt can be substituted for stock options. Debt and managerial equity ownership can also be used as alternative methods in controlling equity agency problems. Within debt use, convertible bonds have different effects in comparison with straight debts.
In dealing with agency problems between equityholders and debtholders, besides using the incentive compensation, convertible bonds are effective tools. With the overuse of ordinary debts, the risk of default is high. Therefore, equityholders through managers will try to gain value at debtholders’ expenses. The introduction of convertible bonds into the existing structure of equity and straight debts gives the bondholders the right to convert debts into equity under some conditions. This conversion right reduces the conflict of interest between the two parties.
- Cost of Capital - Meaning, Significance and Components
- Importance of Capital Structure Planning
- Catastrophe Bonds or CAT Bonds
- Types of Securitization Structures
- Establishing and Maintaining Strong Internal Control
- Agency Theory in Financial Management
- Assessment of Agency Theory
- The Objective of Shareholder Wealth Maximization
- Major Participants in Securitization Process
- Shareholder Value Analysis (SVA)
Leave a Reply Cancel reply
Your email address will not be published. Required fields are marked *
This site uses Akismet to reduce spam. Learn how your comment data is processed .
Activate your 30 day free trial to unlock unlimited reading.
Agency problem & how it can be minimized
You are reading a preview.
Activate your 30 day free trial to continue reading.
Check these out next
Download to read offline
Understanding the Agency Problem Minimizing the agency problem
More Related Content
Slideshows for you (20).
Similar to Agency problem & how it can be minimized (20)
More from Bangladesh Army International University of Science & Technology (18)
Recently uploaded (20)
- 1. Name: Fahmida Haque Shorna ID: 4104051 Major: Finance Level: 4, Term: 1 Assignment Topic: Agency problem & how it can be minimized? Agency problem: 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. Understanding the Agency Problem: 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. Agents are commonly engaged by principals due to different skill levels, different employment positions or restrictions on time and access. For example, a principal will hire a plumber the agent to fix plumbing issues. Although the plumber‘s best interest is to collect as much income as possible, he is given the responsibility to perform in whatever situation results in the most benefit to the principal. The agency problem arises due to an issue with incentives and the presence of discretion in task completion. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way. Minimizing the agency problem: Agency costs are a type of internal cost that a principal may incur as a result of the agency problem. They include the costs of any inefficiency that may arise from employing an agent to take on a task, along with the costs associated with managing the principal-agent relationship and resolving differing priorities. While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk of agency costs.
- 2. Regulations Principle-agent relationships can be regulated, and often are, by contracts, or laws in the case of fiduciary settings. The Fiduciary Rule is an example of an attempt to regulate the arising agency problem in the relationship between financial advisors and their clients. The term fiduciary in the investment advisory world means that financial and retirement advisors are to act in the best interests of their clients. In other words, advisors are to put their clients' interests above their own. The goal is to protect investors from advisors who are concealing any potential conflict of interest. Incentives The agency problem may also be minimized by incentivizing an agent to act in better accordance with the principal's best interests. For example, a 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 or the threat of takeovers.
Public clipboards featuring this slide, select another clipboard.
Looks like you’ve clipped this slide to already.
You just clipped your first slide!
Create a clipboard
Get slideshare without ads, special offer to slideshare readers, just for you: free 60-day trial to the world’s largest digital library..
The SlideShare family just got bigger. Enjoy access to millions of ebooks, audiobooks, magazines, and more from Scribd.
You have now unlocked unlimited access to 20M+ documents!
Learn faster and smarter from top experts
Download to take your learnings offline and on the go
Instant access to millions of ebooks, audiobooks, magazines, podcasts and more.
Read and listen offline with any device.
Free access to premium services like Tuneln, Mubi and more.
Help us keep SlideShare free
It appears that you have an ad-blocker running. By whitelisting SlideShare on your ad-blocker, you are supporting our community of content creators.
- Skip to primary navigation
- Skip to main content
- Skip to primary sidebar
- Skip to footer
Agency Problem Definition
The agency problem can be defined as a conflict when the agents entrusted with the responsibility of looking after the interests of the principals choose to use the power or authority for their benefits and in corporate finance. It is a conflict of interest between its management and stockholders.
It is a common problem in almost every organization, whether a church, club, company or government institution. A conflict of interest occurs when responsible people misuse their authority and power for personal benefits. However, it can be resolved if only the organizations are willing to fix it.
Table of contents
Types of agency problems, solutions to agency problems, recommended articles.
You are free to use this image on your website, templates, etc., Please provide us with an attribution link How to Provide Attribution? Article Link to be Hyperlinked For eg: Source: Agency Problem (wallstreetmojo.com)
Every organization has its own set of long-term and short-term goals and objectives that it wishes to achieve in a predetermined period. In this context, one must also note that the management’s plans may not necessarily align with the stockholders.
The management of an organization may have goals that are most likely derived to maximize their benefits. On the other hand, an organization’s stockholders are most likely interested in their wealth maximization Wealth Maximization Wealth maximization means the maximization of the shareholder’s wealth as a result of an increase in share price thereby increasing the market capitalization of the company. The share price increase is a direct function of how competitive the company is, its positioning, growth strategy, and how it generates profits. read more . This contrast between the goals and objectives of the management and stockholders of an organization may often become a basis for agency problems. Precisely speaking, there are three types which are discussed below: –
- Stockholders vs. Management – Large companies may have many equity Equity Equity refers to investor’s ownership of a company representing the amount they would receive after liquidating assets and paying off the liabilities and debts. It is the difference between the assets and liabilities shown on a company's balance sheet. read more holders. It is always crucial for an organization to separate management from ownership since there is no reason to form a management part. Segregating rights from management has endless advantages as it does not affect regular business operations. The company will hire professionals to manage the key functions of the same. But hiring outsiders may become troublesome for stakeholders Stakeholders A stakeholder in business refers to anyone, including a person, group, organization, government, or any other entity with a direct or indirect interest in its operations, actions, and outcomes. read more . The managers hired may make unjust decisions and misuse the shareholders’ money, which can be a reason for the conflict of interests between the two and agency problems.
- Stockholders vs. Creditors – The stockholders might pick up risky projects to make more profits. This increased risk might elevate the required ROR on the company’s debt Debt Debt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state. read more . Hence, the overall value of the pending debts might fall. If the project sinks, the bondholders will supposedly have to participate in losses, resulting in agency problems with the stockholders and the creditors.
- Stockholders vs. Other Stakeholders – The stakeholders of a company may have a conflict of interests with other stakeholders like customers, employees, society, and communities. For example, the employees might be asking for a hike in their salaries which, if rejected by the stakeholders, there is a probability of agency problems occurring.
ABC Ltd. sells gel toothpaste for $20. The company’s stockholders raised the selling price of the toothpaste from $20 to $22 to maximize their wealth Wealth Wealth refers to the overall value of assets, including tangible, intangible, and financial, accumulated by an individual, business, organization, or nation. read more . This sudden unnecessary rise in the cost of toothpaste disappointed the customers and boycotted the product sold by the company. Few customers who bought the product realized a fall in the quality and were utterly disappointed. It resulted in agency problems between the stockholders and the loyal and regular customers of the company.
There can be various causes of agency problems. These causes differ from the position of an individual in the company. However, the root cause of these problems is the same in all mismatch or conflict of interests cases. When the agenda of the stockholder Stockholder A stockholder is a person, company, or institution who owns one or more shares of a company. They are the company's owners, but their liability is limited to the value of their shares. read more clashes with the other groups, the agency problem will occur. In the case of employees, the reason would be the failure of stockholders to meet employees’ expectations concerning salary, incentives, working hours, etc.
In the case of customers, the cause would be the failure of stockholders to meet customers’ expectations like the sale of poor-quality goods, poor supply, high pricing, etc. In the case of management, the causes of agency problems could be the misalignment of goals, separation of ownership and control, etc.
The companies can resolve the agency problems between the stockholders and the company’s management by offering stock packages or commissions for the decisions taken by the administration and their outcomes on the shareholders Shareholders A shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. read more . In addition, the companies can try to resolve these problems that can exist between its stockholders and management/ creditors/ other stakeholders (employees, customers, society, community, etc.) through taking instituting measures like tough screening mechanisms, offering incentives for good performance, and behavior and likewise penalizing for poor performance and bad behavior, and so on. However, an organization cannot completely heal from agency problems since the associated costs outweigh the total outcomes sooner or later.
Agency problems are the mismatch of interests between the company’s management/ creditors/ other stakeholders (employees, customers, society, community, etc.) and its stockholders, which may sooner or later result in a conflict of interest. Therefore, companies must address the underlying problems to ensure that their regular profit business operations are not impacted. This problem can exist anywhere: a company, club, church, or government institution.
The three types of agency problems: stockholders vs. management, stockholders vs. [wsm-tooltip header="Bondholders" description="A bondholder is an investor who buys or holds a government or corporate bond." url="https://www.wallstreetmojo.com/bondholder/"]bondholders Profit Profit refers to the earnings that an individual or business takes home after all the costs are paid. In economics, the term is associated with monetary gains. read more / creditors, and other stakeholders like employees, customers, community groups, etc. Companies can resolve it with the help of measures like offering incentives for good performance and behavior and penalizing for poor performance and bad behavior, tough screening mechanisms, etc. Of course, it is almost impossible for companies to eliminate agency problems, but it can still minimize the same implications.
This article is a guide to an Agency Problem and its definition. Here, we discuss types and agency problem solutions, their causes, and an example. You can learn more about accounting from the following articles: –
- Agency Cost
- Agency Bond
- Responsibility Center
- Stockholder’s Equity Statement
- Top 10 Wall Street Movies You Must Watch
Leave a Reply Cancel reply
Your email address will not be published. Required fields are marked *
Save my name, email, and website in this browser for the next time I comment.
- Terms of Service
- Advertise with us
- Investment Banking Resources
- Financial Modeling Guides
- Excel Resources
- Accounting Resources
- Financial Statement Analysis
Free Investment Banking Course
Introduction to Investment Banking, Ratio Analysis, Financial Modeling, Valuations and others
* Please provide your correct email id. Login details for this free course will be emailed to you.
8.5 Agency Problems
- What are agency problems and how can they be mitigated?
The principal-agent problem is an important subcategory of moral hazard that involves postcontractual asymmetric information of a specific type . In many, nay, most instances, principals (owners) must appoint agents (employees) to conduct some or all of their business affairs on their behalf. Stockholders in joint-stock corporations, for example, hire professional managers to run their businesses. Those managers in turn hire other managers, who in turn hire supervisors, who then hire employees (depending on how hierarchical the company is). The principal-agent problem arises when any of those agents does not act in the best interest of the principal, for example, when employees and/or managers steal, slack off, act rudely toward customers, or otherwise cheat the company’s owners. If you’ve ever held a job, you’ve probably been guilty of such activities yourself. (We admit we have, but it’s best not to get into the details!) If you’ve ever been a boss, or better yet an owner, you’ve probably been the victim of agency problems. (Wright has been on this end too, like when he was eight years old and his brother told him their lemonade stand had revenues of only $1.50 when in fact it brought in $10.75. Hey, that was a lot of money back then!)
Stop and Think Box
As the author of this textbook ideas.repec.org/a/taf/acbsfi/v12y2002i3p419-437.html and many others have pointed out, investment banks often underprice stock initial public offerings (IPOs). In other words, they offer the shares of early-stage companies that decide to go public for too little money, as evidenced by the large first day “pops” or “bumps” in the stock price in the aftermarket (the secondary market). Pricing the shares of a new company is tricky business, but the underpricing was too prevalent to have been honest errors, which one would think would be too high about half of the time and too low the other half. All sorts of reasons were proffered for the systematic underpricing, including the fact that many shares could not be “flipped” or resold for some weeks or months after the IPO. Upon investigation, however, a major cause of underpricing turned out to be a conflict of interest called spinning: ibanks often purposely underpriced IPOs so that there would be excess demand, so that investors would demand a larger quantity of shares than were being offered. Whenever that occurs, shares must be rationed by nonprice mechanisms. The ibanks could then dole out the hot shares to friends or family, and, in return for future business, the executives of other companies! Who does spinning hurt? Help? Be as specific as possible.
Spinning hurts the owners of the company going public because they do not receive as much from the IPO as they could have if the shares were priced closer to the market rate. It may also hurt investors in the companies whose executives received the underpriced shares who, in reciprocation for the hot shares, might not use the best ibank when their companies later issue bonds or stock or attempt a merger or acquisition. Spinning helps the ibank by giving it a tool to acquire more business. It also aids whoever gets the underpriced shares.
Monitoring helps to mitigate the principal-agent problem . That’s what supervisors, cameras, and corporate snitches are for. Another, often more powerful way of reducing agency problems is to try to align the incentives of employees with those of owners by paying efficiency wages Wages higher than the equilibrium or market clearing rate. Employers offer them to reduce agency problems, hoping employees will value their jobs so much they will try to please owners by behaving in the owners’ interest. , commissions, bonuses, stock options, and the like . Caution is the watchword here, though, because people will do precisely what they have incentive to do. Failure to recognize that apparently universal human trait has had adverse consequences for some organizations, a point made in business schools through easily understood case stories. In one story, a major ice cream retailer decided to help out its employees by allowing them to consume, free of charge, any mistakes they might make in the course of serving customers. What was meant to be an environmentally sensitive (no waste) little perk turned into a major problem as employee waistlines bulged and profits shrank because hungry employees found it easy to make delicious frozen mistakes . (“Oh, you said chocolate. I thought you said my favorite flavor, mint chocolate chip. Excuse me because I am now on break.”)
In another story, a debt collection agency reduced its efficiency and profitability by agreeing to a change in the way that it compensated its collectors . Initially, collectors received bonuses based on the dollars collected divided by the dollars assigned to be collected. So, for example, a collector who brought in $250,000 of the $1 million due on his accounts would receive a bigger bonus than a collector who collected only $100,000 of the same denominator (250/1,000 = .25 > 100/1,000 = .10). Collectors complained, however, that it was not fair to them if one or more of their accounts went bankrupt, rendering collection impossible. The managers of the collection agency agreed and began to deduct the value of bankrupt accounts from the collectors’ denominators. Under the new incentive scheme, a collector who brought in $100,000 would receive a bigger bonus than his colleague if, say, $800,000 of his accounts claimed bankruptcy (100/[1,000 – 800 = 200] = .5, which is > 250/1,000 = .25). Soon, the collectors transformed themselves into bankruptcy counselors! The new scheme inadvertently created a perverse incentive, that is, one diametrically opposed to the collection agency’s interest, which was to collect as many dollars as possible, not to help debtors file for bankruptcy.
In a competitive market, pressure from competitors and the incentives of managers would soon rectify such mishaps. But when the incentive structure of management is out of kilter, bigger and deeper problems often appear. When managers are paid with stock options, for instance, they are given an incentive to increase stock prices, which they almost invariably do, sometimes by making their companies’ more efficient but sometimes, as investors in the U.S. stock market in the late 1990s learned, through accounting legerdemain. Therefore, corporate governance looms large and requires constant attention from shareholders, business consulting firms, and government regulators .
A free-rider problem, however, makes it difficult to coordinate the monitoring activities that keep agents in line . If Stockholder A watches management, then Stockholder B doesn’t have to but he will still reap the benefits of the monitoring. Ditto with Stockholder A, who sits around hoping Stockholder B will do the dirty and costly work of monitoring executive pay and perks, and the like. Often, nobody ends up monitoring managers, who raise their salaries to obscene levels, slack off work, go empire-building, or all three! www.investopedia.com/terms/e/empirebuilding.asp This governance conundrum helps to explain why the sale of stocks is such a relatively unimportant form of external finance worldwide.
Governance becomes less problematic when the equity owner is actively involved in management. That is why investment banker J. P. Morgan used to put “his people” (principals in J. P. Morgan and Company) on the boards of companies in which Morgan had large stakes. A similar approach has long been used by Warren Buffett’s Berkshire Hathaway. Venture capital firms also insist on taking some management control and have the added advantage that the equity of startup firms does not, indeed cannot, trade. (It does only after it holds an IPO Offering of stock to investors with the aid of an investment bank. or direct public offering [ DPO Offering of stock to investors without the aid of an investment bank. ]). So other investors cannot free-ride on its costly state verification. The recent interest in private equity, funds invested in privately owned (versus publicly traded) companies, stems from this dynamic as well as the desire to avoid costly regulations like Sarbanes-Oxley. www.sec.gov/info/smallbus/pnealis.pdf
Investment banks are not the only financial services firms that have recently suffered from conflicts of interest. Accounting firms that both audit (confirm the accuracy and appropriateness of) corporate financial statements and provide tax, business strategy, and other consulting services found it difficult to reconcile the conflicts inherent in being both the creator and the inspector of businesses. Auditors were too soft in the hopes of winning or keeping consulting business because they could not very well criticize the plans put in place by their own consultants. One of the big five accounting firms, Arthur Andersen, actually collapsed after the market and the SEC discovered that its auditing procedures had been compromised. How could this type of conflict of interest be reduced?
In this case, simply informing investors of the problem would probably not work. Financial statements have to be correct; the free-rider problem ensures that no investor would have an incentive to verify them him- or herself. The traditional solution to this problem was the auditor and no better one has yet been found. But the question is, how to ensure that auditors do their jobs? One answer, enacted in the Sarbanes-Oxley Act of 2002 (aka SOX and Sarbox), is to establish a new regulator, the Public Company Accounting Oversight Board (PCAOB) to oversee the activities of auditors. www.pcaobus.org The law also increased the SEC’s budget (but it’s still tiny compared to the grand scheme of things), made it illegal for accounting firms to offer audit and nonaudit services simultaneously, and increased criminal charges for white-collar crimes. The most controversial provision in SOX requires corporate executive officers (CEOs) and corporate financial officers (CFOs) to certify the accuracy of corporate financial statements and requires corporate boards to establish unpaid audit committees composed of outside directors, that is, directors who are not members of management. The jury is still out on SOX. The consensus so far appears to be that it is overkill: that it costs too much given the benefits it provides.
Government regulators try to reduce asymmetric information. Sometimes they succeed. Often, however, they do not. Asymmetric information is such a major problem, however, that their efforts will likely continue, whether all businesses like it or not.
- Agency problems are a special form of moral hazard involving employers and employees or other principal-agent relationships.
- Agency problems can be mitigated by closely aligning the incentives of the agents (employees) with those of the principal (employer).
- Regulations are essentially attempts by the government to subdue the Cerberus of asymmetric information.
- Some government regulations, like laws against fraud, are clearly necessary and highly effective.
- Others, though, like parts of Sarbanes-Oxley, may add to the costs of doing business without much corresponding gain.
Through regulations or by incentivizing an agent to act in accordance with the principal's best interests, agency problems can be reduced. 1:36. Agency Problem
Perhaps the simplest method for eliminating the agency problem is to remove financial incentives that encourage conflicts of interest. Returning
How can you mitigate an agency problem? · Practice transparency · Use concise contract language · Introduce corporate governance · Seek intervention
Performance Evaluation and Performance Measurement · Risk and Reward Sharing · Corporate Governance and Internal Control · Communication and Conflict Resolution.
Greater financial leverage can help reduce the agency costs by impacting managers including threat of liquidation, and the pressure of making money to pay for
lead toward the better company profit-the goal that the shareholders strive to as their main interest. ... increasing the value of the shares. Eun and Resnick (
In other words, advisors are to put their clients' interests above their own. The goal is to protect investors from advisors who are concealing any potential
read more/ creditors, and other stakeholders like employees, customers, community groups, etc. Companies can resolve it with the help of measures like offering
That's what supervisors, cameras, and corporate snitches are for. Another, often more powerful way of reducing agency problems is to try to align the incentives
Carolina, the University of South Carolina, the 1995 American Finance Association meetings ... Several mechanisms can reduce these agency problems.