Competing Stakeholder Interests

Shareholder vs. Stakeholder Theory

Shareholder theory posits that the most important responsibility of a company’s managers is to maximize shareholder returns. Stakeholder theory, on the other hand, emphasizes the need for a company to consider the needs of all its stakeholders and not just its shareholders. This includes the company’s customers, suppliers, creditors, employees, and essentially anyone interested in the company.

Capital structure decisions impact stakeholder groups differently. Increased leverage increases the risk to all stakeholders but only results in a higher return for shareholders.

Debt vs. Equity Conflict

Debtholders have a contractual and prior claim to cash flows and firm assets over shareholders. Their potential return is limited. Equity holders have more downside risk but a much higher upside potential. Therefore, debt holders will prefer lower leverage levels, and equity holders will prefer higher leverage levels that offer them greater return potential.

Other Debt Considerations

Seniority and Security

In case of default, secured debt lenders are likely to recover more than unsecured lenders. Likewise, senior debt is likely to recover more than subordinated debt. Consequently, secured debt and senior debt lenders can tolerate management actions that increase leverage.

Long-term vs. Short-term debt

Debtors are exposed to probable changes in a business environment, strategy, and management conduct as time passes.

Safeguard for Debtholders

• Debt covenants can limit the amount of debt a company can take and limit management actions that increase the risk to debt holders. Positive covenants state what the borrower must do, while negative covenants state what the borrowers cannot do.
• Companies want to keep their credit access and conditions favorable, so they’ll take steps to retain or improve their creditworthiness if they need to borrow in the future.
• Financial distress costs can be substantial.

Preferred Shareholders

Preferred shares have debt and equity-like characteristics. They are ranked ahead of common shareholders but after debt holders in terms of security and priority of dividend payments. Failure for the company to pay preferred shareholders dividends is not considered a default, but it prevents the payment of dividends to common shareholders until preferred shares dividends are paid. Issuing preferred shares is less risky to the company’s debt holders and equity holders than issuing debt.

Preferred shareholders are vulnerable to management’s actions that increase financial leverage and risk as they lack covenant protection that debt holders may have.

Private Equity Investors/Controlling Shareholders

When a company has one or more large shareholders, retirement or issuance of common shares affects voting control of the company.

Majority shareholders may have objectives that conflict with minority shareholders. Majority equity shareholders exercise control through the appointment of board members and senior management. Controlling shareholders can pursue expansion strategies that may not increase shareholders’ value that minority shareholders can not block.

Controlling shareholders seeking to sell their stake might take a short-term view on financing, while companies that are founder-led and founder-controlled benefit from the long-term view that founders take on the businesses.

Bank and Private Lenders

There are stakeholders differences between holders of public debt, private debt, and bank lenders that arise from differences in investment time horizon and stakeholder access to information. To make investment decisions, public market debtholders rely on public information and credit rating agency conclusions. They may not hold debt securities to maturity.

Bank and private lenders generally hold company debt to maturity. They usually have direct access to firm management and non-public company information, which decreases information asymmetry in theory. Bank lending policies are generally conservative, while private lenders vary widely in risk appetite, approach, behavior, and relationships with companies to whom they have provided capital.

Other Stakeholders

Customer and Supplier

Suppliers are typically short-term creditors. Suppliers are not willing to extend additional credit to companies in financial distress. Customers and suppliers have an interest in a company’s long-term stability.

Employees

Employees have a direct financial stake in their employer through equity-oriented participation plans and in the company’s long-term growth. Equity ownership is a minor part of compensation and less important than the company’s stability and growth.

Management and Directors

Management and directors are hired to maximize shareholder wealth resulting in the debt/equity conflict. A good compensation should align interest interests between managers/directors and shareholders.

Regulators and Government

Regulators are key stakeholders. For financial institutions, certain capital adequacy levels must be maintained. Additionally, utilities might have the prices of their products determined by the government or regulator.

Distressed companies may also seek government support to remain in business. Such support might come with certain conditions like block dividends and constraints on financing decisions.  

 Question

Which of the following tools are most likely used by debt holders to align the company’s interest and debt holders?

1. Compensation.
2. Debt covenants.
3. Equity ownership.

Solution

The correct answer is B

Debt covenants are lending agreements between lenders and the borrowing company that are used to align the interest of both parties.

A is incorrect. Compensation is used to align the interests between management and directors, and shareholders.

C is incorrect. Equity ownership aligns individuals’ incentives with the interests of the company.  It also encourages everyone involved to think long-term, which is key for company success.