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 or reluctant to make investments, effectively manage costs, or make 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: Management compensation and status often correlate with the size of the business which can motivate managers to chase “growth for growth’s sake,” such as acquisitions that do not boost 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 Theory

According to agency theory, managers are supposed to carry out their responsibilities to increase business value and fulfill shareholders’ interests.

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 either dispersed on concentrated. Dispersed ownership implies that a company has many shareholders, with none controlling the corporation.

On the other hand, concentrated ownership implies that among the shareholders of the company, 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 between minority and controlling shareholders can occur. Such conflicts arise when the influence of the controlling shareholders eclipses the opinions or desires of the minority shareholders.

Manager and Board Relationships

Whereas managers are involved in the day-to-day operations of a company, the board of directors, especially the non-executive board members, are not. This leads to information asymmetry and makes it difficult for the board to perform its functions effectively.

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.

Under empire building (pursuit of excessive growth), managers are encouraged to pursue acquisitions even though they might not boost shareholder value. This happens when directors’ and management’s remuneration is based on the size of the company.

A is incorrect. Entrenchment is where excessive pay avoids risk for one to hold onto one’s position. Directors refrain from criticizing management for being able to maintain their positions.

C is incorrect. Excessive risk-taking is where a compensation plan heavily relying on stock grants and options encourages management to take excessive risks.