Agency theory refers to the relationship between the principal and the agent in a contract. The agent is acting on behalf of the principal to create a contractual relationship with a third party. At the end of the transaction, the principal is expected to pay a commission to the agent. When the principal expects the agent to go the extra mile such as bearing the burden of debts by the third party, a del credere commission is paid.
The agency theory can also be applied in the relationship between shareholders and directors. Directors act as agents of the shareholders by taking part in business activities. And the investors expect that their investment will be maximized. However, directors want a commission and other rewards for their services. This resulted in agency conflicts.
Agency relationships and the board of directors
The board of directors should make decisions that are in the best interest of the company. As a result, they may seek funds. Funds are provided through shareholders (equity) and bondholders (debt). This leads to a conflict in two relationships. The board and the shareholders are on one end, and the debt holders are on the other. Note that a debtholder is not part of the agency relationships.
Directors and shareholders
A newly founded company is managed by the owners (founders shareholders). As the company grows there is a need to separate ownership from management. As a result, some founders become either the chairman or the CEO of the company. Next, the need for finance will result in having more shareholders. These holders need their wealth to be maximized either by paying dividends/or by an increase in share price.
But the directors also want rewards for directing the business. This leads to conflicts. Directors may push for short-term profitability, which may not maximize the shareholders' wealth. To resolve this conflict, executive directors are paid remuneration that is both variable, fixed, and share-based.
Debtholders and directors
In addition to equity finance, directors may seek alternative funds through the debt market. The debtholders want sound use of financial resources by the directors. They will release their fund if they believe that the company can repay the interest and debt sum. For directors, they will also favour debtholders first before shareholders. Failure to pay them on the due date may lead to loss of reputation with shareholders.
How agency theory affects the boardroom
The board of directors is responsible for directing the activities of a company. In doing so they must consider all stakeholders' interests and power. More so, the directors have an agency relationship with their principal, the shareholders. As stated earlier, shareholders' wealth maximisation is an important aspect for the directors.
In making decisions in the boardroom, directors ensure that they consider the shareholders' objectives. Therefore, they will make decisions that have a long-term benefit to the company and its investors. However, shareholders are not the only stakeholders with power and influence. Knowing this, directors will balance the needs of all stakeholders of the company when making decisions.
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