Principal-Agent Relationship

The term ‘principal-agent relationship’ or simply ‘agency relationship’ describes an arrangement where one entity, the principal, legally appoints another entity, the agent, to act on its behalf by providing a service or performing a particular task. In most cases, there is information asymmetry between the principal and the agents with the agents possessing more information than the principal.

The agent is expected to act in the best interest of the principal. It is, however, not unusual for principal-agent relationships to lead to conflicts. The most common example of this occurs when managers, acting as agents, do not act in the best interest of the shareholders of a company (the principals).

When these conflicts arise, they give rise to agency costs. Agency costs are costs incurred to reduce conflicts between the principal and the agents. They may be direct, such as employing monitoring agents like auditors, or indirect, such as forgone benefits of missed opportunities.

Shareholder and Manager/Director Relationships

Directors and managers (agents) are expected to act in the best interests of the shareholders (principal) by maximizing a company’s equity value. These two groups, however, tend to have conflicting interests on issues related to the risks that a company should undertake. Managers and directors tend to act more risk-averse to protect their employment status. On their part, shareholders want directors and managers to accept more risk to maximize equity value.

In addition, managers usually have greater access to information and are more knowledgeable about a company’s affairs than the shareholders. This information asymmetry makes it easier for managers to make strategic decisions that are not necessarily in the best interests of shareholders.

Managers’ and stockholders’ interests are rarely perfectly aligned. Manager compensation can help motivate managers to maximize shareholder value.

Examples of conflicts include:

1. Lack of adequate effort from the managers, for instance managers may allocate very little time to their roles and most of their time to activities that do not necessarily promote the company’s growth.
2. Inappropriate risk appetite – Managers with options or stock grants as compensation may take excessive risk that may increase share prices. On the other hand, managers without stock grants or options may become risk averse.
3. Entrenchment – Managers may do whatever is needed of them to keep their jobs even if it means avoiding speaking out against management even if speaking out benefits the company’s stakeholders.
4. Empire Building – Managers may pursuit growth for growth’s sake even if that growth does not increase shareholder value as their compensation is typically tied to company size and not necessarily share value.
5. Self-interest – Managers may use company resources, for example club memberships, for their self-benefit as opposed to using it for the company’s benefit/ growth.

Controlling and Minority Shareholder Relationships

Corporate ownership can be classified as dispersed or concentrated. Dispersed ownership implies that a company has many shareholders, none of whom control the corporation.

On the other hand, concentrated ownership implies that among the company’s shareholders, there are controlling shareholders who have authority over the corporation.

Another factor that determines whether a company is concentrated or dispersed is the shareholder voting structures and share classes with varying degrees of voting rights.

In a simple voting structure, one shareholder carries one vote. In contrast, a dual-class structure involves one share class, say class A, that bears one vote per share and is publicly held and traded, and another class, say class B, that bears multiple votes per share and is entirely owned by company founders or insiders.

Clearly, the dual-class structure gives some of the corporation’s shareholders the power to control the company even if they do not have significant shares outstanding.

Minority shareholders usually have limited or no control over the management. Similarly, they have limited or no voice in director appointments or significant transactions that could directly impact shareholder value.

As a result, conflicts can occur between minority and controlling shareholders. Such conflicts arise when the influence of the controlling shareholders eclipses the opinions or desires of the minority shareholders.

Shareholder vs. Creditor (Debtholder) Interests

Creditors’ interest is to have a company undertake activities that promote stable financial performance as this guarantees the maintenance of default risk at an acceptable level and the return of creditors’ principal and interest payments by the company. On the other hand, shareholders prefer to have a company venture into riskier activities with high return potential and are, as such, more likely to enhance equity value. There is, therefore, a divergence of interest in risk tolerance between these two groups.

Question

Which of the following instances of conflict of interest between managers and shareholders is most likely a result of managers’ compensation being tied to the company’s size?

1. Entrenchment.
2. Empire building.
3. Excessive risk-taking.

The correct answer is B.

Empire building refers to the behavior of managers who expand the size or scope of their company beyond what is necessary or beneficial for shareholders.

When managers’ compensation is directly linked to the company’s size, they may have incentives to pursue empire-building to increase their own compensation, even if it is not in the best interests of shareholders. This can lead to inefficiencies, increased operating costs, and lower returns for shareholders.

A is incorrect. Entrenchment typically occurs when managers prioritize their own job security or personal interests over maximizing shareholder value. It often involves actions such as resisting changes to management or corporate governance structures that could potentially threaten their positions or compensation. While entrenchment can be a form of conflict of interest between managers and shareholders, it is not directly related to managers’ compensation being tied to the company’s size.

C is incorrect. Excessive risk-taking refers to the situation where managers pursue overly risky strategies in an attempt to maximize short-term gains or meet performance targets, often at the expense of long-term shareholder value. This is more related to managers’ incentives to take on excessive risks to achieve certain performance metrics or bonuses rather than their compensation being tied to company size.