Shareholder vs. Stakeholder Theory

The shareholder theory states that the most important responsibility of managers is to serve the interests of shareholders.

The stakeholder theory states other parties' interest should be considered too. These other parties include the company's customers, suppliers, employees, managers, debt-holders and shareholders.

Capital structure decisions impact stakeholders differently. Increased leverage increases risk for all stakeholders, but could benefit the group of shareholders only.

Debt vs. Equity Conflict

The agency cost of debt is the conflict that arises between shareholders and debtholders of a public company.

Debtholders are typically interested in safe investments. Their potential return is limited. Equityholders, however, have a much higher upside potential. They often prefer higher leverage that offer them greater return potential.

Seniority and Security: Secured and senior debt lenders can recover more in a default scenario than unsecured or junior debt owners. They can therefore better tolerate risky decisions by management.

Long-term vs. Short-Term Debt: the longer term, the greater the equity/debt conflict.

Safeguards for Debtholders: Debt covenants are the primary tools for debtholders. They state what the borrower must do (positive covenants) and cannot do (negative covenants). Companies also want to keep good track record for future borrowings. Substantial financial distress costs is also a consideration.

Preferred Shareholders

Preferred shares have debt and equity-like characteristics. Preferred shareholders provide long-term capital without maturity date and covenant protection. They are vulnerable to decisions that increase financial leverage and risk.

Private Equity Investors/Controlling Shareholders

Majority shareholders may have objectives that conflict with minority shareholders. They may take a short-term view on financing, or long-term view on strategic growth. They can be different from what the minority shareholders want.

Bank and Private Lenders

Different lenders have different agendas. Public market debtholders may not hold the debt to maturity and may make decisions on bond prices.

Bank and private lenders generally hold company debt to maturity. They usually have direct access to firm management and non-public company information, which decreases information asymmetry in theory. Bank lending policies are generally conservative. Private lenders vary widely in risk appetite, approach, behavior, and relationships with companies to whom they have provided capital.

Other Stakeholders

Customers and Suppliers: Suppliers are short-term creditors. They both naturally prefer long-term stability of the company.

Employees: Most employees in most businesses prefer the company's stability and growth to equity ownership.

Management and Directors: Compensation can be used to motivate managers to work hard to maximize the shareholder value, which typically results in debt/equity conflict. However, such compensation can be excessive, or motivate risk-taking behavior.

Regulator and Government: They are often key stakeholders. For example, regulators may set the max price charged by utility companies. Certain solvency levels must be kept for financial institutions.

Practice Question 1

Higher financial leverage increase risk to:

I. shareholders
II. debtholders
III. customers
IV. suppliers
V. employees

Correct Answer: All of them

Increased leverage increases the risk to all stakeholders but only results in a higher return for shareholders.

Practice Question 2

What is false regarding private lenders?

A. They rely on public information and credit rating criteria to make investment decisions.
B. They usually hold debt securities to maturity.
C. They prefer less financial leverage.

Correct Answer: A

They typically have direct access to company management and non-public information. They generally hold debt securities to maturity. Like all debtholders, they prefer less financial leverage and less risk.