Agency Theory

The relationship between the business owners and the management team is always complicated when both parties are not in unison. Agency theory is a business principle that explains the relationship between business principals and their agents who represent them in day to day business activities. The theory includes the problems facing the relationship and their possible solutions. A typical example of the agency relationship is shareholders, who are the real owners of a company, and the company executives, who are agents acting on behalf of the shareholders. Though there seems to be no permanent solution to the agency problems, measures to minimize these problems do exist.

            One of the agency problems is a conflict of interest. An agent is expected to always act on his principal’s best interest by making decisions that are in favor of his boss other than being in favor of himself (Bosse, Douglas, & Phillips, 2016, p.276). From a business perspective, the management is expected to make decisions that are aimed at maximizing the shareholders’ wealth. However, this does not always happen, and the management may make decisions that maximize their wealth and not that of the shareholders. This kind of problem is difficult to solve because balancing the interest of the principal and that of the agent also requires a proper balance of the risk involved.

            Another problem faced in an agency relationship is a different attitude towards risk. Business executives who run the business on behalf of shareholders have a different perception of risk from the business owners. For example, managers of a bank may set a few restrictions on the loan approval process to increase the number of customers. On the other hand, shareholders may prefer more restrictions on the same to minimize the risk of loan defaults, which might negatively affect their wealth. Secondly, managers may propose financing a new project from the profits reserves while the shareholders will be proposing the distribution of such funds as dividends proceeds. While managers have not been able to address most of these problems altogether, there are some measures put in place to minimize these problems.

            Changing the reward system can be used to minimize the agency problem. A company can set incentives to encourage hard work on the projects which benefit the company directly may shift the interests of employees to be consistent with that of their bosses (Panda, Brahmadev & Leepsa, 2017, p.74). The company’s objectives can be set in a way to ensure that the goals of the agent are aligned with that of his principal to bridge the gap of interest between the two parties. Another solution will be introducing corporate governance, such as the board of directors or external auditors to overlook the managers and ensure that decisions that are taken are consistent with the shareholders’ interests.

            In conclusion, solving the problems arising from the agency relationship is not a straight forward thing as it involves balancing the interests of the agent and that of the principal. However, the prudent thing is to ensure managers are not given the autonomy of decision making and that their activities are reviewed from time to time by an independent body of experts such as auditors.  

References

Bosse, Douglas A., and Robert A. Phillips. “Agency theory and bounded self-interest.” Academy of Management Review 41.2 (2016): 276-297.

Panda, Brahmadev, and N. M. Leepsa. “Agency theory: Review of theory and evidence on problems and perspectives.” Indian Journal of Corporate Governance 10.1 (2017): 74-95.