Agency cost is the sum of money spent from a company's treasury due to employing directors as agents to run the entity on behalf of the shareholders. This cost is to ensure that directors are responsible for their decisions and rewarded for their efforts rather than for lavish spending. More so, a conflict of interest between executive directors and shareholders results in agency costs.
What should you know?
When a company is established, the founders operate the business and make decisions. In this situation, there is no agency cost. However, to expand the business, these founders seek funds from shareholders through venture capitalists, stock exchange markets, and M&As. As a result, there is a need for accountability and transparency to these investors. This leads to conflicts of interest between executive directors and shareholders resulting in agency costs.
The more stakeholders' interest in a company, the greater the need to ensure transparency and lower agency costs. Aside from accountability and transparency, directors have access to information about the company that its shareholders do not. And they make decisions on behalf of the company. Therefore, they can make decisions that will benefit them rather than the maximisation of shareholders' wealth.
Multinational companies and global venture enterprises have a higher agency cost compared to medium-sized companies. They have multiple stakeholders from different cultural backgrounds and ethics. Therefore, their corporate governance must be firm. Executive directors must be monitored by the board to ensure that they do not favour themselves rather than the company.
When companies spend money on agency costs, it reduces their profits and, of course, the dividends to be paid to shareholders. Note that since dividends are paid out of profit, lower profits mean smaller dividend payout.
The three primary agency costs
Below we discussed three costs that affect shareholders.
1. Monitoring costs
This is the cost of monitoring, measuring, and controlling the activities of the executive directors. The goal of this cost is to ensure transparency and accountability. For example, the chairman of the board of directors may outsource the services of a management consultant to evaluate the activities of the directors.
Another example is the cost of preparing the financial statements and accounts of the company as well as the external audits of such accounts. The company law of Nigeria explicitly states that directors are responsible for preparing the books of accounts of the company. The amount spent on the aforementioned is monitoring costs.
2. Bonding costs
Directors have an interest in the company that is different from the shareholders. To ensure senior management and shareholders have the same goal, the company will incur bonding costs. This is the cost of ensuring that the interests of the directors are similar to the shareholders.
An example is incentives provided to directors through share options. If directors are issued free shares or shares at a reduced price, this will align their interests with those of shareholders. Because they will be shareholders of the company.
Therefore, their decisions and actions will be in the best interest of the company. Also, senior management can be paid variable income and a fixed salary. The variable salary KPIs are based on their performance. KPI may include increasing the earnings per share or the total shareholders' return.
3. Residual loss
Board members and other stakeholders, including the chairman, may try to use bonding and monitoring costs to reduce agency conflicts. However, there may be residual. This is the remaining cost incurred by the company as a result of differences between the goals of the directors and shareholders.
An example of residual loss is when the executive management decides to acquire another company. This goal is to increase the size of the company, but it might harm shareholders' returns. The directors’ decision may be to increase shareholders' wealth from the merger and acquisition, but external economic conditions may change it.
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