Agency Problem Definition
The agency problem can be better defined as a conflict taking place when the agents who are entrusted with the responsibility of looking after the interests of the principals chose to use the power or authority for their personal benefits and in corporate finance, it can be explained as a conflict of interest taking place between the management of a company and its stockholders.
It is a very common problem and it can be observed in almost every organization irrespective of the fact that whether it is a church, club, company or any government institution. It is a conflict of interest taking place that takes place when people who are interested in responsibilities misuse their authority and power for personal benefits. It can be resolved only if the organizations are willing to resolve it.
Types of Agency Problems
Every organization has its own set of long-term and short-term goals and objectives that it wishes to achieve in a pre-determined period of time. In this context, it must also be noted that the goals of the management may not necessarily align with that of the stockholders.
The management of an organization may have goals that are most likely derived with the motive of maximizing their personal benefits while on the other hand, the stockholders of an organization are most likely interested in their wealth maximizationWealth MaximizationWealth maximization means the maximization of the shareholder’s wealth as a result of an increase in share price thereby increasing the market capitalization of the company. The share price increase is a direct function of how competitive the company is, its positioning, growth strategy, and how it generates profits.. This contrast between the goals and objectives of the management and stockholders of an organization may often become a basis for agency problems. Precisely speaking there are three types which are discussed below-
- Stockholders vs Management – Large companies may have a huge number of equity holders. It is always crucial for an organization to separate the management from ownership since there is no reason for them to form a part of management. Segregating ownership from management has endless advantages as it does not have any implications upon the regular business operations and the company will hire professionals for managing the key operations of the same. But hiring outsiders may become troublesome for stakeholders. The managers hired may take unjust decisions and might even misuse the shareholders’ money and this can be a reason for the conflict of interests between the two and hence, agency problems.
- Stockholders v/s Creditors – the stockholders might pick up risky projects for making more profits and this increased risk might elevate the required ROR on the company’s debt and hence, the overall value of the pending debts might fall. If the project sinks, the bondholders will supposedly have to participate in losses and this can result in agency problems with the stockholders and the creditors.
- Stockholders v/s other Stakeholders – The stakeholders of a company may have a conflict of interests with other stakeholders like customers, employees, society, and communities. For example, the employees might be asking for a hike in their salaries which if rejected by the stakeholders then there are probabilities of agency problems to take place.
ABC Limited sells gel toothpaste at $20. The stockholders of the company raised the selling price of the toothpaste from $20 to $22 in order to maximize their wealth. This sudden unnecessary rise in the price of the toothpaste disappointed the customers and they boycotted the product sold by the company. Few customers who bought the product realized a fall in the quality and were utterly disappointed. This resulted in the agency problems between the stockholders and the loyal and regular customers of the company.
There can be various causes of agency problems. These causes differ from the position of an individual in the company. The root cause of these problems is the same in all cases that are mismatch or conflict of interests. When the agenda of the stockholderStockholderA stockholder is a person, company, or institution who owns one or more shares of a company. They are the company's owners, but their liability is limited to the value of their shares. clashes with the other groups then the agency problem is definitely going to take place. In the case of employees, the reason would be the failure of stockholders to meet employees’ expectations with respect to salary, incentives, working hours, etc.
In the case of customers, the cause would be the failure of stockholders to meet customers’ expectations like the sale of poor quality goods, poor supply, high-pricing, etc. In the case of management, the causes of agency problems could be the misalignment of goals, separation of ownership and management, etc.
Solutions to Agency Problems
The agency problems existing between the stockholders and the management of the company can be resolved by means of offering stock packages or commission to the decisions taken by the management and their outcomes on the shareholders. The companies can try to resolve these problems that can exist between its stockholders and management/ creditors/ other stakeholders (employees, customers, society, community, etc) by means of taking instituting measures like tough screening mechanisms, offering of incentives for good performance and behavior and likewise penalizing for poor performance and bad behavior, and so on. However, it is not possible for an organization to get completely healed from agency problems since the costs associated have the tendency to outweigh the total outcomes sooner or later.
Agency problems are nothing but the mismatch of interests between the company’s management/ creditors/ other stakeholders (employees, customers, society, community, etc) and its stockholders which may sooner or later result in a conflict of interest. It is highly crucial for companies to address the underlying problems to ensure that its regular business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation. are not getting impacted. This type of problem can exist anywhere whether it is a company, club, church or even government institutions.
The three types of agency problems are stockholders v/s management, stockholders v/s bondholders/ creditors, and stockholders v/s other stakeholders like employees, customers, community groups, etc. It can be resolved by companies with the help of measures like offering incentives for good performance and behavior and likewise penalizing for poor performance and bad behavior, tough screening mechanisms, and so on. It is almost impossible for companies to completely eliminate agency problems but it can still minimize the implications of the same.
This has been a guide to Agency Problem and its definition. Here we discuss types and examples of agency problems along with its causes, and solutions. You can learn more about accounting from the following articles –