Corporations have much more complex structures than other forms of organization and therefore problems come along the way.
One key difference between corporations and other forms of organization is separation of control and ownership. The agency problem, also known as the “principal-agent problem”, is a conflict of interest when someone (the principal) hires another (the agent) to act in his or her best interests. The problem is that the agent is supposed to make decisions to best serve the principal’s best interests while the agent’s own best interests may be different from the principal’s best interests. In a corporation, the management is the agent and the stockholders are the principal. For example: a firm is considering a new investment which is expected to positively impact the stock price, but it is considered to be relatively risky. According to the shareholders’ best interest, the firm should take the investment as the stock price will rise, while the management may prefer not because it is possible that the investment will go bad given the high risk and they will lose their job because of the bad performance. If the management doesn’t make the investment, the shareholders lose the opportunity of gaining more potential earnings – it is called agency cost.
To solve the agency problem, there are generally two solutions:
- Control of the firm. To monitor the management and ultimately control the firm, the shareholders elect board of directors who hires and fires management. The managers are under the pressure of the board to try to maximize the wealth of the shareholders, or else they will be replaced.
- Managerial compensation. It is impossible for the board to monitor the management perfectly. An alternative to monitoring is to motivate the managers to act in shareholders’ best interests through compensation, including performance-based bonuses, stock options, and promotion.
Sometimes the agency problem situation can be very complex. For example, management’s performance is measured by the company’s performance in both the short term and the long term, therefore the decision they made are based on a long-term goal. However many shareholders, who don’t intend to hold the stock for a long time, are more interested in immediate return therefore they prefer a dividend instead of reinvesting the money to achieve a long-term development and growth which is not the perfect way to operate the business. Another example is the board of directors may have a different opinion from the shareholders and the management. Conflicts among three entities can be very difficult to resolve.
