An agency relationship may be defined as a contract under which one or more people (the principals) hire another person (the agent) to perform some services on their behalf, and delegate some decision making authority to that agent. Within the financial management framework, agency relationship exist between:
(a) Shareholders and Managers
(b) Debtholders and Shareholders
4.1 Shareholders versus Managers
A Limited Liability company is owned by the shareholders but in most cases is managed by a board of directors appointed by the shareholders. This is because:
i) There are very many shareholders who cannot effectively manage the firm all at the same time.
ii) Shareholders may lack the skills required to manage the firm.
iii) Shareholders may lack the required time.
Conflict of interest usually occur between managers and shareholders in the following ways:
i) Managers may not work hard to maximize shareholders wealth if they perceive that they will not share in the benefit of their labour.
ii) Managers may award themselves huge salaries and other benefits more than what a shareholder would consider reasonable
iii) Managers may maximize leisure time at the expense of working hard.
iv) Manager may undertake projects with different risks than what shareholders would consider reasonable.
v) Manager may undertake projects that improve their image at the expense of profitability.
vi) Where management buy out is threatened. ‘Management buy out’ occurs where management of companies buy the shares not owned by them and therefore make the company a private one.
Solutions to this Conflict
In general, to ensure that managers act to the best interest of shareholders, the firm will:
(a) Incur Agency Costs in the form of:
i) Monitoring expenses such as audit fee;
ii) Expenditures to structure the organization so that the possibility of undesirable management behaviour would be limited. (This is the cost of internal control)
iii) Opportunity cost associated with loss of profitable opportunities resulting from structure not permit manager to take action on a timely basis as would be the case if manager were also owners. This is the cost of delaying decision.
(b) The Shareholder may offer the management profit-based remuneration. This remuneration includes:
i) An offer of shares so that managers become owners.
ii) Share options: (Option to buy shares at a fixed price at a future date).
iii) Profit-based salaries e.g. bonus
(c) Threat of firing: Shareholders have the power to appoint and dismiss managers which is exercised at every Annual General Meeting (AGM). The threat of firing therefore motivates managers to make good decisions.
(d) Threat of Acquisition or Takeover: If managers do not make good decisions then the value of the company would decrease making it easier to be acquired especially if the predator (acquiring) company beliefs that the firm can be turned round.
4.2 Debt holders versus Shareholders
A second agency problem arises because of potential conflict between stockholders and creditors. Creditors lend funds to the firm at rates that are based on:
i. Riskiness of the firm's existing assets
ii. Expectations concerning the riskiness of future assets additions
iii. The firm's existing capital structure
iv. Expectations concerning future capital structure changes.
These are the factors that determine the riskiness of the firm's cashflows and hence the safety of its debt issue. Shareholders (acting through management) may make decisions which will cause the firm's risk to change. This will affect the value of debt. The firm may increase the level of debt to boost profits. This will reduce the value of old debt because it increases the risk of the firm.
Creditors will protect themselves against the above problems through:
a. Insisting on restrictive covenants to be incorporated in the debt contract. These covenants may restrict:
The company’s asset base
The company’s ability to acquire additional debts
The company’s ability to pay future dividend and management remuneration.
The management ability to make future decision (control related covenants)
b. if creditors perceive that shareholders are trying to take advantage of them in unethical ways, they will either refuse to deal further with the firm or else will require a much higher than normal rate of interest to compensate for the risks of such possible exploitations.
It therefore follows that shareholders wealth maximization require fair play with creditors. This is because shareholders wealth depends on continued access to capital markets which depends on fair play by shareholders as far as creditor's interests are concerned.