Agency Theory

Agency theory helps explain the relationship between principals and agents. An agency relationship occurs whenever an individual or entity (the principal) hires an agent to act in the principal’s best interest. Agency relationships can occur in many contexts. For example, athletes and movie stars often hire agents to promote their interests, including their financial interests in contract negotiations. Agency theory is primarily concerned with for-profit organizations and explains how shareholders act as principals by hiring managers to serve as agents on their behalf. In some cases, the owners and the managers can actually be the same individuals. But in large, publicly traded corporations, there is almost always a separation between the owners and managers of the firm. Because of this separation of ownership and control, there is the potential for agency costs to rise, where managers (agents) may act in ways that are not in the best interests of the owners (principals) of the firm. Agency theory largely deals with diagnosing and resolving these issues that inherently arise in agency relationships in most firms. Agency theory has implications for corporate reputation because agency problems can potentially lead to actions by management that harm the reputation of the firm. The following sections outline the agency problem in more detail and explain how this problem is overcome.

The Agency Problem

There are a number of reasons why the agency problem exists in modern corporations. First of all, the interests, preferences, and goals of the principal and agent can come into conflict. For example, a manager may value job security and therefore reduce the level of risk that he or she is willing to bear. Shareholders on the other hand, who can diversify their risk across many firms, may prefer that managers engage in riskier strategies that have the potential for greater returns. Managers and owners may also have different preferences about the time horizons over which they are seeking a return. Second, it is difficult for the principal to monitor the agent and know precisely what the agent is doing. In publicly traded firms, there is inherent information asymmetry between the agent and principal. For example, it can be difficult for shareholders to know whether managers are exerting appropriate effort or whether they are shirking their responsibilities. In addition, it can be very difficult for the principal to know if an agent has all of the skills he or she claims, which makes it difficult to select the right manager for the job.

Overcoming the Agency Problem

There are a number of ways in which firms attempt to overcome the agency problem and ensure that an agent truly works on behalf of the principal. The first way is through direct monitoring of the agent. Much of this direct monitoring occurs through the board of directors. Shareholders elect a board of directors to represent their interests and give to the board the authority to hire, compensate, and replace management. From an agency theory perspective, boards have the responsibility to monitor the actions of management and to take corrective action if managers act in ways that do not promote the interests of owners. Agency theory predicts that independent directors (those who are not employed by the focal firm and who do not have business or family relationships with management) are best suited to carry out this monitoring function of the board. In addition to the board, shareholders may at times directly monitor the actions of management. While smaller individual shareholders have little incentive to closely monitor management, larger investors, such as institutional investors with a sizable stake in a firm, have greater incentives to directly monitor the actions of management. At times, these large shareholders can apply direct pressure on firms to make significant changes if managers act contrary to their interests.

A second method that is often used to overcome the agency problem is the use of incentive-based compensation. Agency theory suggests that compensation arrangements can be used to align the incentives of managers and shareholders. Tying compensation to performance is a common practice that is used to motivate managerial action. In particular, making managers part owners of the company through the use of stock compensation is thought to align the incentives of managers and shareholders.

A third way in which the agency problem can be reduced is through what is known as the market for corporate control. This simply means that managers are motivated to run the firm efficiently and deliver a return to shareholders because if they don’t, outside owners can take over the firm and replace the board and management team with individuals who will deliver better performance.

Impact and Criticism

Agency theory has had a tremendous impact on modern thinking about corporations. In particular, many of the factors that are widely considered to represent good corporate governance are consistent with the tenets of agency theory. For example, independent boards and contingent compensation have been widely adopted by large firms. It is also the case that firms with practices that run counter to the prescriptions of agency theory can suffer reputational damage. However, despite its apparent impact, agency theory has been criticized as offering an overly simplistic and undersocialized view of the modern corporation that focuses primarily on shareholders without recognizing the importance of a broader set of stakeholders to the firm. In addition, many of the mechanisms highlighted by agency theory have been shown in empirical research to have little to no effect on the financial performance of firms.