Agency Theory

Extract from "Pierre Vernimmen, Corporate Finance: Theory & Practice" John Wiley &
Sons. (p 639-641, 992)
Agency problems occur in a company when ownership is separated from management.
Managers may be tempted to achieve their own objectives instead of the financial objective. We explore these problems in the discussion which follows.
Agency theory says that a company is not a single, unified entity. It calls into question the claim that all of the stakeholders in the company (shareholders, managers and creditors) have a single goal – value creation. Agency theory shows how, on the contrary, their interests may differ and some decisions (related to borrowing, for example) or how products (stock options) come out of attempts to achieve convergence between the interests of managers and shareholders to protect creditors. It analyses the consequences of certain financial decisions in terms of risk, profitability and, more generally, the interests of the various parties. Agency theory is the intellectual basis of corporate governance.

Agency theory says that a company is not a single, unified entity. It considers a company to be a legal arrangement that is the culmination of a complex process in which the conflicting objectives of individuals, some of whom may represent other organisations, are resolved by means of a set of contractual relationships.
On this basis, a company’s behaviour can be compared to that of a market, insofar as it is the result of a complex balancing process. Taken individually, the various stakeholders in the company have their own objectives and interests that may not necessarily be spontaneously reconcilable. As a result, conflicts may arise between them, especially since our modern corporate system requires that the suppliers of funds entrust the managers with the actual administration of the company.
Agency theory analyses the consequences of certain financial decisions in terms of risk, profitability and, more generally, the interests of the various parties. It shows that some decisions may go against the simple criteria of maximising the wealth of all parties to the benefit of just one of the suppliers of funds.
To simplify, we consider that an agency relationship exists between two parties when one of them, the agent, carries out an activity on behalf of the other, the principal. The agent has been given a mandate to act or take decisions on behalf of the principal. This is the essence of the agency relationship.
This very broad definition allows us to include a variety of domains, such as the resolution of conflicts between:
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executive shareholders/non-executive shareholders;

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nonshareholder executives/shareholders;

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creditors/shareholders.

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Thus, shareholders give the company executives a mandate to manage to the best of their ability the funds that have been entrusted to them. However, their concern is that the executives could pursue objectives other than maximising the value of the equity, such as increasing the company’s size at the cost of profitability, minimising the risk to capital employed by rejecting certain investments that would create value but could put the company in difficulty if they fail, etc.
One way of resolving such conflicts of interest is to use stock options or linking management compensation to share performance. This gives managers a financial incentive that coincides with that of their principal, the shareholders. Since stock options give the holders the right to buy or subscribe to shares at a fixed price, the managers have a financial incentive to see the price of their company’s shares rise so that they receive significant capital gains. It is then in their interests to make the financial decisions that create the most value. In France over half of listed companies have set up stock option plans.
Variable
part accounts for 50%–66% of top executives’ compensations in Western European countries. In the USA this figures amounts to 85% which is mainly due to profitsharing plans.

Debt plays a role as well since it has a constraining effect on managers and encourages them to maximise cash flows so that the company can meet its interest and principal payments.
Failing this, the company risks bankruptcy and the managers lose their jobs. Maximising cash flows is in the interests of shareholders as well, since it raises the value of shareholders’ equity. Thus, the interests of management and shareholders converge. Maybe debt is the modern whip!

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The diverging interests of the various parties generate a number of costs called “agency costs”. These comprise:
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the cost of monitoring managers’ efforts (control procedures, audit systems, performance-based compensation) to ensure that they correspond to the principal’s objectives. Stock options represent an agency cost since they are exercised at less than the going market price for the stock;

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the costs incurred by the agents to vindicate themselves and reassure the principals that their management is effective, such as the publication of annual reports;

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residual costs.

Ang et al. (2000) have shown that the margins and asset turnover rates of small- and mediumsized American firms tend to be lower in companies managed by nonshareholding CEOs, and in which managers have little stake in the capital and many nonexecutive shareholders.
The main references in this field are Jensen and Meckling (1976), Grossman and Hart (1980), and Fama (1980). Their research aims to provide a scientific explanation of the relationship between managers and shareholders and its impact on corporate value.
Their main contribution is to try and compare financial theory and organisational theory. This research forms the intellectual foundation on which the concept of corporate governance was built.
Corporate governance attempts to regulate the decision-making power of executives to ensure that they do not serve their own vested interests to the detriment chiefly of shareholders, but also of creditors, employees and the company in general.
These developments have caused treasury shares, cross-shareholdings and voting right restrictions to be called into question. More board of director meetings are being held and a percentage of listed companies have set up committees to monitor internal auditing, compensation and the re-election of executives or directors. On a sample of 100 large French companies, 75% had established similar committees and 85% had independent directors with no links to company executives or the large shareholders. Of S&P 500 corporations, 81% of directors were independent directors in 2006 and the CEO was the only insider in 39% of boards. Similarly, the number of directorships held by the same person has been limited to five,[4] executive compensation is now routinely disclosed and the, unlisted companies. accounts are released more rapidly. All these measures are designed to give shareholders more control over managers.
[4] Not including directorships in controlled

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