Shareholders who owns the company are called principals and management who runs the company on behalf of the shareholders are called shareholder’s agents.
Conflicts between shareholders and management’s objectives create agency problem. Because, shareholders’ main priority involves seeking new investments to raise share value, while management may pursue job security, corporate luxury, and high compensation at the expense of shareholders.
Conflicts of interests between principal and agent results in agency cost which include:
- Corporate expenditure that benefits management, but costs stockholders. For example, a company buying an unneeded corporate jet.
- The expense that arises from the need to monitor management actions. For example, an outside auditor hired to review financial statements.
- Lost opportunities. For example, a company not taking a merger which could benefit the shareholders but not the management.
How to Mitigate Agency Problem?
Agency problems are mitigated by good systems of corporate governance. The most important measure is managerial compensation which could gather the interests of shareholders and management. For example, managers are spurred on by incentive schemes that produce big return if shareholders gain but are valueless if they do not. Besides, managers who pursue shareholders’ goals are in greater demand.