We will not consider sole proprietorship further in this chapter.
We will not consider sole partnership further in this chapter.
An agency relationship arises when:
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.
I. incentive fees paid to managers.
A. A principal-agent conflict exists with all business forms.
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.
A. Corporations can exist forever.
Another advantage is corporations can hire professional managers.
A. the manager has an incentive to take actions that will increase the company's stock price and make her option more valuable.
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.
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.
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.
A. A manager is choosing between two projects. He prefers the larger project even though it has lower NPV.
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.