Subject 3. Forms of business and conflicts of interest

There are three types of firms. The structure chosen determines how the owners share the risks and liabilities of the firm and how they participate in the making of decisions.

Proprietorship

  • It is a business firm owned by an individual who possesses the ownership right to the firm's profits and is personally liable for the firm's debts.
  • The proprietor often works directly for the firm, providing managerial and other labor services.
  • Proprietorship account for 73 percent of the businesses in the US, but only 6 percent of all business revenues.
  • Examples: neighborhood grocery stores, barbershops, farms.
  • Corporate governance perspective: Since the manager and the owner are the same, this form presents fewer risks than the corporation.

    • The owner has the type and quality of information needed to evaluate various risks of the firm.
    • The owner can also easily monitor the condition and the risks of the business, and control the business' risk exposure.

    We will not consider sole proprietorship further in this chapter.

Partnership

  • It is a business firm owned by two or more individuals who possess ownership rights to the firm's profits and are personally liable for the debts of the firm.
  • In terms of owner liability there is no difference between a proprietorship and a partnership.
  • Partnership account for 7 percent of the businesses in the US, and 5 percent of all business revenues.
  • Examples: law, medical and accounting firms.
  • Corporate governance perspective: Partners typically overcome conflicts of interest internally by engaging in partnership contracts specifying the rights and responsibilities of each partner.

    We will not consider sole partnership further in this chapter.

Corporation

  • It is a business firm owned by shareholders who possess ownership rights to the firm's profits, but whose liability is limited to the amount of their investment in the firm.
  • This is an attractive corporate structure since:

    • Stockholders' liability is limited to the extent of their explicit investment.
    • Ownership can easily be transferred.

  • Corporations accounts for 20 percent of businesses in the U.S. but 90 percent of total revenues.
  • Corporate governance perspective: It's difficult for shareholders to monitor management and the firm's operations.

Agency Relationships

An agency relationship arises when:

  • The principal hires an agent to perform some services.
  • The decision-making authority is delegated to the agent.
  • However, the agent is not fully responsible for the decision that is made.

Since the agent and the principal may have different goals, the agency relationship creates a potential conflict of interest.

Conflicts among the various constituencies in corporations have the potential to cause problems in the relationships among managers, directors, shareholders, creditors, employees, and suppliers. Below we consider two relationships which are the primary focus of most systems of corporate governance.

Stockholders and Managers

The agency problems arise whenever the managers own less than 100% of the firm.

Firms and their managers obtain operating and investing capital from the shareholders in various ways: IPOs, retained earnings, or SEOs (seasoned equity offering), etc. When a company's shareholders (the principal) delegate decision-making authority to the managers (the agent), a potential conflict of interest arises. The goal of shareholders is to maximize shareholder value. The goals of managers' are job security, power, status, compensation, more opportunities for lower and middle managers, etc. In essence, the fact that the owner-manager will neither gain all the benefits of the wealth created by his or her efforts nor bear all of the costs of perquisites will increase the incentive to take actions that are not in the best interests of other shareholders.

In most large corporations, potential agency conflicts are important since large firms' managers generally own only a small percentage of the stock. Strong corporate governance systems provide mechanisms for monitoring managers' activities, rewarding good performance and disciplining those in a position of responsibility for the company to make sure they act in the interests of the company's stakeholders.

Directors and Shareholders

Board members (directors) should act in the best interests of shareholders. They should ensure that shareholders' interests are being well-served. The purpose is to provide an intermediary between managers and shareholders. They are generally responsible for monitoring the activities of managers, approving strategies and policies and making certain that these serve investors' interests.

Directors must make decisions based on what ultimately is best for the long-term interests of shareholders. The conflict arises when directors come to identify with the managers' interests rather than those of the shareholders as a result of personal or business relationships with managers.

Practice Question 1

Shareholders in the modern corporation are normally separate from management. Management acts as the agents of the shareholders. Managers may act in their own self-interest sometimes, the agency costs of resolving these shareholder-manager conflicts are made up of:

I. incentive fees paid to managers.
II. shareholder monitoring costs and incentive fees.
III. takeover defense costs.
Correct Answer: I, II and III

Practice Question 2

Which of the following statements is false with respect to the major forms of businesses and the corporate governance risk inherent in each of them?

A. A principal-agent conflict exists with all business forms.
B. A sole proprietorship possesses the fewest forms of corporate governance risk of all the business forms possible.
C. With partnerships, an effective corporate governance system is possible if the partners reach agreements with respect to the rights and responsibilities of each partner.
D. Among all the business forms, the need for an effective governance system is perhaps most important for corporations.
Correct Answer: A

While with sole proprietorship and partnerships the owners take an active role in managing the business, with corporations the role of owner and manager are usually separated, thus creating a principal-agent conflict. Thus, an effective corporate governance system is required so that the interests of shareholders are held in management decisions.

Practice Question 3

The following are advantages of separation of ownership and management of corporations except:

A. Corporations can exist forever.
B. Facilitate transfer of ownership without affecting the operations of the firm.
C. Incur agency costs.
Correct Answer: C

Another advantage is corporations can hire professional managers.

Practice Question 4

Assume that a manager has been awarded an executive stock option that allows her to purchase 1,000 shares of the company's stock at a price of $10 per share. The current price of the company's stock is $8.25 per share. This executive stock option helps reduce the agency problem because:

A. the manager has an incentive to take actions that will increase the company's stock price and make her option more valuable.
B. the manager has an incentive to take actions that will decrease the company's stock price and make her option more valuable.
C. the manager has an incentive to take actions that will decrease the company's stock price even though these actions will make her option less valuable.
Correct Answer: A

The executive stock option allows the manager to buy the company's stock at a price of $10 per share regardless of the current market price of the stock. This means that the option becomes more and more valuable as the market price of the stock exceeds $10 per share. As a result, the manager has an incentive to work to increase the value of the company's stock, and the agency problem is decreased.

Practice Question 5

Which of the following statements is false with respect to the types of principal-agent problems?

A. Managers, who hold an excessive position in the shares of their company relative to their individual portfolios, may be induced to avoid even moderate risk projects in an effort to safeguard their capital investment.
B. The principal-agent problem is largely between shareholders and managers. There exists no such conflict between shareholders and directors.
C. Managers, who hold stock options as opposed to shares, may be induced to take high risk projects.
Correct Answer: B

A principal-agent conflict may arise between shareholders and directors if the directors cite with management point of view at the expense of shareholders interest. This conflict may especially arise if the directors are not entirely independent, i.e., they hold personal or business relations with the firm or its managers.

Practice Question 6

Which of the following situations does not represent an agency conflict?

A. A manager is choosing between two projects. He prefers the larger project even though it has lower NPV.
B. A manager fires an employee for charging personal expenses to the company for a business road trip.
C. A manager invests in riskier projects after borrowing funds in a debt issue.
Correct Answer: B

Firing an employee for charging personal expenses to the company is not an example of agency conflict. In this case, the manager is performing his duty as shareholders would like her to, maximize firm's profits.