Agency Theory

• The separation of ownership and control results in agency costs.
• The agency theory poses a potential conflict of interest between the stockholders and managers. Such conflicts starts when the stockholders entrust to the managers the authority to make decision for the firm. The managers, with the power vested upon them, may have personal goals that clash with the stockholder’s wealth maximization.
• This theory exists due to the creation of an agency relationship. This relationship is borne as soon as an individual or group of people, called the principals, hire the service of an individual or organization called an agent, to perform a service and exercise decision-making for the principal
• Agency relationships between stockholders and managers can be problematic when the manager owns a small percentage of the company's stock
• In a sole proprietorship, the manager aims to maximize personal wealth
• When the company becomes a corporation, the owner-manager may relax and use more earnings, knowing that some costs will be borne by other stockholders
• In large corporations, potential agency conflicts are more common when managers do not own a small percentage of the company's stocks
• Incentives for good performance include:

  • Salary increases
  • Bonuses
  • Stock options
  • Promotions
  • Travel
• Punishments for poor performance may include:

  • No bonus
  • Termination threats
  • Salary reductions
• Companies may use threats of takeovers and shutdowns to ensure managers act in the best interest of stockholders