Agency Problem: Meaning, Types, Agency Costs

Agency Problem Meaning and Definition

Agency theory is related to the behavior of two interested parties of the firm, like owners and managers. An agency problem results when managers, as agents for owners, place personal goals ahead of corporate goals.

Meaning of Agency Theory

Agency problem is a situation in which the interests of the principal (shareholder or owner of a business) and the agent (a manager or board of directors) are not aligned.

An agency problem occurs when the agent is entrusted with acting on behalf of the principal and making decisions that are in the best interests of the principal, but the agent instead acts in their own self-interest or the interests of another party.

The agency problem can arise from business corporations, partnerships, finance, marketing, planning, and other business operations.

Good corporate governance policies, performance incentives, and oversight from external parties can help resolve the agency’s problem.

Definition of Agency Theory

An agency problem is a potential conflict of interest that can arise between a principal and an agent.

  • Agency problem is the potential conflict between principals (shareholders) and agents (managers). – C. P. Jones
  • Agency problem is the likelihood that managers may place personal goals ahead of corporate goals. – L. J. Gitman
  • The lack of perfect alignment between the interests of managers and shareholders results in the agency problem. – Prasanna Chandra
  • Agency theory is a branch of economics relating to the behavior of principals (such as owners) and their agents (such as managers). – Van Home

Type of Agency Problems in Financial Management Context

Financial managers can be viewed as agents of the owners who have hired them and given them decision-making authority to manage the firm. Most financial managers would agree with the goal of owner wealth maximization.

In practice, managers are also concerned with their personal wealth, job security, and other benefits. However, managers may have personal goals that compete with shareholder wealth maximization, and agency theory deals with such potential conflicts of interest

From this conflict of the owner and personal goals arises what has been called the agency problem. Within the financial management context, the agency’s problems are those:

  1. Conflict between stockholders and managers.
  2. Conflict between stockholders and creditors.
  3. Conflict between owners and other parties.

Resolving the Agency Problem

From the conflict of management objective of personal goals and maximizing owner’s value arises the agency problem. The agency problem can be minimized by acts of

  1. market forces, and
  2. agency costs.

Market Forces

Market forces act to minimize agency problems in two ways:

1. Major Shareholders:

To exercise the major shareholders’ legal voting rights, the large institutional shareholders communicate with and exert pressure on corporate management to perform or face replacement.

2. Threat of Takeover

The constant threat of a takeover would motivate management to act in the best interests of the owners despite the fact that techniques are available to define against a threat takeover.

Agency Costs

Agency cost refers to the cost of resolving conflicts of interest among stockholders, bondholders, and managers. Agency cost includes all costs designed or incurred to encourage managers to maximize shareholders’ wealth rather than act in their own self-interest. Basically, agency costs are borne by shareholders.

The cost incurred by stockholders to minimize agency problems is called agency cost. Agency cost arises by shareholders to prevent or minimize agency problems and to work towards the maximization of shareholders’ wealth.

To minimize agency problems, the owners have to incur four types of costs, which are:

1. Monitoring Expenditures

The monitoring outlays relate to payment for audit and control procedures to ensure that managerial behavior is tuned to actions that tend to be in the best interest of the shareholders.

2. Bonding Expenditures

The firm pays to obtain a fidelity bond from a third-party bonding company to the effect that the latter will compensate the former up to a specified amount for financial losses caused by dishonest acts of managers.

3. Opportunity Costs

Such costs result from the inability of large companies to respond to new opportunities. The management may face difficulties in seizing profitable investment opportunities quickly.

4. Structuring Expenditures

The most popular, powerful, and expensive method is to structure management compensation to correspond with share price maximization. The objective is to give managers incentives to act in the best interests of the owners. The two key type’s compensation plans are:

  1. Incentive Plans: The most popular incentive plan is the granting of stock options to managers. These options allow managers to purchase stock; if the market price rises, z managers will be rewarded.
  2. Performance Plans: The forms of performance-based compensation are cash bonuses, cash payments tied to the achievement of certain performance goals.

Most firms today use a package of economic incentives, along with some monitoring, to influence the manager’s performance and thus reduce the agency problem.

The following incentives or factors that motivate managers are discussed below:

Performance-based compensation plans

Managers’ compensation usually depends on the company’s performance. If any organization is performing better, the managers can be compensated, and the compensation can be in the form of:

  • A specified annual salary designed to cover living expenses,
  • A bonus paid at the end of the year, which depends on the company’s profitability during the year and
  • Options to buy stock, or actual shares of stock, reward the executive for the firm’s long-term performance.

Direct intervention by shareholders

Although a great deal of stock is owned by individuals, an increasing percentage is owned by institutional investors such as

insurance companies, pension funds, and mutual funds. These institutional investors can force the firm’s managers to improve their performance and sometimes give suggestions regarding how the business should be run.

The threat of firing

The CEOs or other top executives can be forced out of office due to the company’s poor performance.

The threat of a takeover

Hostile takeovers are most likely to occur when a firm’s stock is undervalued relative to its potential. In a hostile takeover, the managers of the acquired firm are generally fired. Thus, managers have a strong incentive to take actions that maximize stock prices and possibly to avoid taking over.