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Agency relationship and conflicts between business managers and shareholders

Updated on July 1, 2017

An agency relationship arises whenever a person or a group of persons hire another person or a group of persons to perform some service on behalf of the former.  The Principal, on whose behalf the Agent performs the particular service, delegates the decision making authority to the agent.

In large firms, shares are likely to be diversely held. In such circumstances, the actions of shareholders are likely to be restricted in practical terms. Therefore, the responsibility of running the business will be with the board of directors. The directors may own only a small percentage of the share capital of the company. When ownership is so separated from the day-to-day management of the firm, a possible conflict can arise. The managers of the firm are essentially agents of shareholders. They are appointed for running the firm in the shareholders’ best interests. However shareholders have little opportunity to assess whether the managers are acting in the shareholders’ best interests.

Managers may be encouraged to behave in ways that are not most favourable to the shareholders of the company. Shareholders can spread their risk by investing in a number of firms. But the managers may be averse to investing in risky investments. Although shareholders wealth is maximized by investing in projects with positive net present values, managers may be more interested in short term payback in order to help further their own promotional prospects. Managers of firms which are subject to takeover bids often try to resist the predator. When the takeover bid succeeds, the managers of the acquired company often lose their jobs and status while the shareholders of the acquired company often receive large gains in the value of their shares. Managers may be motivated to award themselves and the staff better terms and conditions of service which will incur costs and reduce profits. If shareholders are losing as a result, they may sell their shares and the market value of the firm will fall. 

Therefore the agency relationship between shareholders and managers has agency conflicts, or conflicts of interest between agents and principals. It has implications for corporate governance and business ethics. It also has agency costs which are costs incurred in order to maintain an effective agency relationship such as management performance bonuses to persuade managers to act in the shareholders' interests.

Agency theory attempts to explain elements of organizational behaviour through an understanding of the relationship between principals and agents. According to agency theory there may be conflicts between the actions undertaken by agents in furtherance of their self interest and those required to promote the interests of the principals. Agency theory suggests that managers may seek to maximize their own benefit at the expense of shareholders.

One way of dealing with shareholder-manager agency conflicts is that managers are compensated on the basis of changes of the value of the business. Since managers have great incentives to maximize shareholder wealth, the agency costs are low in this case. The other method of dealing with the problem is shareholders monitoring every managerial action. This method is extremely costly and inefficient. The most favourable solution lies between these two extremes where managers compensation is coupled with the performance while monitoring their actions. Large companies employ performance shares schemes where shares of the company are offered to managers on the basis of financial performance such as earnings per share, return on assets, return on equity, and share price. These compensation schemes are designed to ensure managers take actions that will enhance shareholder wealth and to facilitate companies attract and retain the best managers.

In a profit-making organization, it is essential for all members of the management team and their staff work together and achieve the strategic objectives of the organization. The situation which leads the individuals or groups to take actions which are in their self-interest and also in the best interest of the organization is called Goal Congruence.

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      Muhammad Waqas 15 months ago

      How to reduce these conflicts and increase the profitability ratio????

    • profile image

      sha 2 years ago

      how to resolve it?

    • profile image

      Mildred monds 2 years ago

      typing........

    • LasanthaW profile image
      Author

      Lasantha Wijesekera 2 years ago from Sri Lanka

      Thanks for your comments.

    • eastgw profile image

      Rory Duran Davis 2 years ago

      I enjoyed your introduction to agency theory. While performance-based compensation is deployed to align agents ' interests with those of their shareholders, it is important to note that this form of compensation is not a panacea in rectifying agency problems. Often times, because compensation is based on performance, managers are likely to take on projects that are riskier in order to meet personal performance metrics. Consequently, firms could suffer financially if said projects do not meet financial expectations.

    • profile image

      Johne536 2 years ago

      I like what you guys tend to be up too. Such clever work and coverage! Keep up the very good works guys I've incorporated you guys to my personal blogroll. bbbekgdafdee

    • profile image

      Kamaghe, M 2 years ago

      Education is liberation. Managers are educated that is why are given opportunity to work on behalf of shareholders, thus they have to play their parts diligently by averting any unethical events in their leading firms for meeting the objectives. Managers fear to God and do things in a right way.I believe through changing our mindset we reach to the peak

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      Prince 3 years ago

      Explain with full defination pls

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      Moses 3 years ago

      Great! An area challenging. are mangers saints?

    • Dennis AuBuchon profile image

      Dennis AuBuchon 3 years ago

      This is not only interesting it identifies a situation which may or may not exist with the corporate structure. Itdepends on the character and integrity of the individuals the stockholders elected. I voted up, useful, awesome and interesting along with liking, tweeting and pinning.

      Keep up the good work

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      Huang 4 years ago

      Αυτό κάτι θυμίζει:" The state is currently suiidbszing two types of renewable energy production wind and solar parks, and only large-scale ones, which is a prerequisite for attracting foreign investors aiming to making quick profit, Deliyski stated in order to support of Danev's argument that speculators are entering the Bulgarian renewable energy sector.Η φράση quick profit είναι όλα τα λεφτά.Kaymakchalan

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      Vanessa 4 years ago

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      Tarak 5 years ago

      Please explain With full defination .its cont understand non commerce student

    • BizVT34 profile image

      BizVT34 5 years ago from USA

      Although a bit complicated, some of the principles above should be looked at by small business owners who suffer more often from a lack of oversight and accountability. An advisory board could help many small businesses achieve results similar to the larger businesses described above.