Investopedia: What is the 'Agency Theory'?

Agency Theory

What is the 'Agency Theory'

The agency theory is a supposition that explains the relationship between principals and agents in business. Agency theory is concerned with resolving problems that can exist in agency relationships due to unaligned goals or different aversion levels to risk. The most common agency relationship in finance occurs between shareholders (principal) and company executives (agents).
VIDEO
BREAKING DOWN 'Agency Theory'
Agency theory addresses problems that arise due to differences between the goals or desires between the principal and agent. This situation may occur because the principal isn’t aware of the actions of the agent or is prohibited by resources from acquiring the information. For example, company executives may have a desire to expand a business into other markets. This will sacrifice the short-term profitability of the company for prospective growth and higher earnings in the future. However, shareholders that desire high current capital growth may be unaware of these plans.

Contrasting Risk Appetites

Another central issue dealt with by agency theory handles the various levels of risk between a principal and an agent. In some situations, an agent is utilizing resources of a principal. Therefore, although the agent is the decision-maker, they are incurring little to no risk because all losses will be the burden of the principal. This is most commonly seen when shareholders contribute financial support to an entity that corporate executives use at their discretion. The agent may have a different risk tolerance than the principal because of the uneven distribution of risk.
Third Party Relationships

An agency, in general terms, is the relationship between two parties, where one is a principal and the other is an agent who represents the principal in transactions with a third party. Agency relationships occur when the principals hire the agent to perform a service on the principals' behalf. Principals commonly delegate decision-making authority to the agents. Because contracts and decisions are made with third parties by the agent that affect the principal, agency problems can arise.
Other Examples of Principal-Agent Relationships

Agency theory handles numerous situations in which one party acts on the behalf of the other. Financial institutions are given the responsibility of generating shareholder wealth. However, its business practice forces it to incur risk by issuing loans – some of which are outside the comfort level of shareholders. Financial planners and portfolio managers are agents on behalf of their clients and the client’s investments. Finally, a lessee may be in charge of protecting and safeguarding assets that do not belong to themselves. Even though the lessee is tasked with the job of taking care of the assets, the lessee has less interest in protecting the goods than the actual owners.
Next Up Principal

    Agency Theory
    Agency Problem
    Principal
    Agent
    Principal-Agent Problem
    Paying Agent
    Captive Agent
    Power of Attorney
    Independent Agent
    Principal Reduction

Agency Problem
Share
Video Definition

The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. In corporate finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize his own wealth.

!--break--While it is not possible to eliminate the agency problem completely, the manager can be motivated to act in the shareholders' best interests through incentives such as performance-based compensation, direct influence by shareholders, the threat of firing and the threat of takeovers.
Principal-Agent Relationship

The agency problem does not exist without a relationship between a principal and an agent. In this situation, the agent performs a task on behalf of the principal. This may arise due to different skill levels, different employment positions or restrictions on access.

For example, a principal will hire a plumber — the agent — to fix plumbing issues. Although the plumber‘s best interest is to make as much income as he can, he is given the responsibility to perform in whatever situation results in the most benefit to the principal.
Incentives

The agency problem arises due to an issue with incentives. An agent may be motivated to act in a manner that is not favorable for the principal if the agent is presented with an incentive to act in this way. For example, in the plumbing example earlier, the plumber may make three times as much money by recommending a service the agent does not need. An incentive (three times the pay) is present, and this causes the agency problem to arise.
Reducing and Eliminating the Agency Problem

The agency problem may be minimized by altering the structure of compensation. If the agent is paid not on an hourly basis but by completion of a project, there is less incentive to not act on the principal’s behalf. In addition, performance feedback and independent evaluations hold the agent accountable for their decisions.
Historical Example of Agency Problem

In 2001, energy giant Enron filed for bankruptcy. Accounting reports had been fabricated to make the company appear to have more money than what was actually earned. These falsifications allowed the company’s stock price to increase during a time when executives were selling portions of their stock holdings. Although management had the responsibility to care for the shareholder’s best interests, the agency problem resulted in management acting in their own best interest.
BREAKING DOWN 'Agency Problem'

    Work With Investopedia
    About Us Advertise With Us Write For Us Contact Us Careers

© 2017, Investopedia, LLC. Feedback All Rights Reserved Terms Of Use Privacy Policy