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.

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).

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. Examples of conflicts include:

• Lack of Adequate Effort: Managers may be incapable of making investments, effectively managing costs, or making tough choices such as closing unprofitable business segments. Inadequate monitoring of employees or lack of control may lead to unintentional risks and potential legal issues.
• Misaligned Risk Appetite: Compensation packages heavily reliant on stock grants and options may drive excessive risk-taking by management, as these benefit from rising share prices. Conversely, minimal usage of such incentives can result in overly cautious decision-making and difficulty attracting skilled personnel. This misalignment may conflict with the company’s goal of value creation or shareholders’ preference for high-risk, high-reward ventures.
• Pursuit of Excessive Growth: Managers may seek growth purely to increase business size, driven by compensation and status tied to the company’s scale, even if the growth doesn’t enhance shareholder value.
• Entrenchment: Directors and managers aim to keep their positions. Strategies to achieve this may include emulating competitors, risk avoidance, and undertaking complex transactions and restructurings they are uniquely qualified to handle.
• Self-interest: Managers might use company resources to maximize personal gains, such as excessive benefits, or deceive investors by misusing assets. The lesser the manager’s stake in the company, the less they bear these costs personally, reducing their motivation to maximize company value.

Agency Costs

When an agent acts on behalf of a principal, conflicts of interest may increase expenses related to reducing these conflicts. These costs are known as agency costs. Agency costs can be direct costs, such as employing monitoring agents like auditors, or indirect costs, such as forgone benefits of missed opportunities.

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—for instance, a family company.

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 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. This guarantees the maintenance of default risk at an acceptable level. Further, it essentially guarantees a safe return of their principal and payment of interest 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.