Principal–Agent Conflicts and Stakeholder Goals

It is often said that business is all about relationships. Businesses themselves are all about relationships as well. The various stakeholders in a corporation work with each other or against each other in pursuing various goals, and this can create conflicts to manage.

Consider the relationship between shareholders and managers. Managers like to pay themselves more money, which lowers profits for the shareholders. They also know more about the internal operations of the company, and this information asymmetry can help them to make decisions which benefit themselves, even at the expense of the shareholders.

Yet another conflict between the manager of a firm and a shareholder of that firm (and probably many others) is in their risk aversion. Which of these two parties do you think would be more willing to accept a risky new project for the firm?

Actually, the shareholder, not the manager, would likely be more amenable to risky new projects.

That's right!

The shareholder is likely diversified across many firms, and so it's not a big deal if this one firm loses some money. But the manager is dependent on this single firm for income, and so will tend to be more risk-averse. Such conflicts are illustrative of a __principal-agent relationship__, where the shareholders are the principals, and the managers are the agents who are supposed to act in the best interest of the principal. Clearly, they don't always do that, though. Costs arising from these conflicts are called __agency costs__.

Even among the shareholders themselves, conflicts can arise. Large shareholders can have a controlling stake, and get to make all of the decisions. Sometimes this can be a real disadvantage for minority stockholders. Even without a controlling stake, major shareholders who own a big chunk of the firm's stock have a lot more decision-making power than minority shareholders. If there's an offer on the table for a sale of some shares at a premium price, those controlling shareholders are often first in line to get that offer, leaving the minority shareholders out in the cold. That doesn't seem fair.

There are also related-party transactions to consider. Suppose a major shareholder got management to make a large inventory purchase from the shareholder's brother, for example. Assuming the higher cost inventory that was purchased from the shareholder's brother is sold through, how might that harm the other shareholders?

Yes! If that purchase would have been made anyway, then no problem. But if the shareholder is pushing to get this purchase made, then it's probably not the most competitive price. The firm is paying a higher price than necessary to please the shareholder. This will increase costs, and lower profits. So all shareholders suffer suboptimal profits, but the majority shareholder will be happy to help out the brother (and may get a nice gift from him on the side... that's how those things often work).

No, there's no reason to expect this materials purchase to affect sales or pricing, necessarily.

No, cash would be exchanged for inventory that's overvalued, so if anything, assets would be overstated.

Shareholders are often at odds with company creditors as well. The creditors want to get their loans paid back, and the shareholders want higher profits (or specifically, earnings per share). Suppose a decision is made to increase leverage: the firm uses a little more debt and a little less equity. Who do you think would be happy about this?

No, the creditors wouldn't like this at all. More debt means more risk of default.

Absolutely. This would certainly not make the creditors happy. If the firm is adding debt, or at least as a percentage of assets, then that makes the firm more risky. There's more interest expense to pay, and there's a higher chance of default. No good for the creditors. But the shareholders are going to amplify earnings. As long as the firm makes positive profits, a higher level of debt translates into higher earnings per share, and the shareholders love that. Sure, it's more risk, but again, shareholders are diversified anyway.

No, one of these two would probably like this. Consider again the goals of each party.

Customers also fit into the mix. Customers want safer products, but that costs the firm more money and reduces profits for shareholders. Customers also want to buy on credit, but that reduces cash flow available to pay suppliers. It also adds risk to the creditors for timely payment. And yet another relationship is that with government. Banks seem to like using leverage to increase profits, but they also seem to like government bailouts when things go wrong. So banks like higher leverage, and regulators may require lower leverage. Managing all of these relationships simultaneously can be a challenge.

To summarize: [[summary]]

The manager

The shareholder

Profits may be lower

Revenues may be lower

Assets may be understated

Just the creditors

Just the shareholders

Neither shareholders nor creditors

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