What it means
Whenever ownership and control are separated, a gap opens. The owner wants the business run to maximise its value; the manager wants a good salary, a secure job, a pleasant working life, a large empire and, sometimes, a quiet retirement.
Most of the time the two coincide, but not always. A manager may resist a takeover that would benefit shareholders but end his tenure; may make an acquisition that increases his importance but reduces returns; may spend on perks and headquarters; may hoard cash rather than return it; may take too little risk to protect his position, or too much because the downside falls on shareholders.
Each of these is an agency cost borne by the owners. Owners respond in three ways, all of which cost money.
They monitor: independent directors, external auditors, disclosure requirements, analyst coverage and shareholder meetings all exist partly to watch management. They bond: managers are required to report, to follow policies, to seek approval for large decisions.
And they align: performance-related pay, share ownership requirements and option schemes are attempts to make managers think like owners, though badly designed incentives create agency problems of their own, such as manipulating earnings to hit targets. The lender-borrower relationship has parallel costs.
Once a loan is made, shareholders may be tempted to increase risk, pay themselves dividends or take on more debt, all at the lender's expense. Lenders respond with covenants, security, monitoring and higher interest rates, and the cost of those protections is an agency cost of debt that raises the company's cost of capital.
Agency costs explain much of corporate governance and much of finance theory. They are why boards exist, why executive pay is structured as it is, why debt can discipline managers by forcing them to generate cash, and why private equity firms, which concentrate ownership and control, claim to run businesses better.
They cannot be eliminated, only reduced to the point where the cost of further reduction exceeds the benefit.
In practice
Real-world examples.
Example
A chief executive rejects a takeover offer at a 40% premium, citing strategic independence, and the share price falls back to its previous level; shareholders bear the difference.
Example
A family-owned company hires a professional managing director and, after two years of expanding overheads and a new head office, introduces a bonus scheme based on cash generation.
Example
A bank includes a covenant restricting dividends in a loan to a mid-sized company, to prevent shareholders from extracting cash that would weaken the lender's position.
Think of it
“Agency costs are like the overhead of having employees. Sometimes their interests don't perfectly align with yours, and that creates costs.
Formula
Calculation
Total Agency Cost = Monitoring Costs + Bonding Costs + Residual Loss (the value lost despite monitoring and bonding)
Agency costs are rarely measured directly, but their components can be estimated for a specific decision.
Worked example. A listed company has $500 million of surplus cash. Shareholders' best use would be a return of capital, which would earn them about 9% elsewhere. Management instead proposes to keep the cash and use $300 million to acquire a business in a new sector, projecting a 6% return.
- Value lost by shareholders on the acquisition = $300 million x (9% minus 6%) = $9 million a year, a present value at 9% of $100 million
- Value lost on the retained $200 million earning 2% in the bank = $200 million x (9% minus 2%) = $14 million a year
To prevent such decisions, shareholders bear monitoring and alignment costs:
- Independent board and committees: $3 million a year
- External audit and governance reporting: $4 million a year
- Long-term incentive plan for executives tied to return on capital: $8 million a year in expected cost
If the incentive plan and board succeed in blocking the acquisition and forcing a $400 million return of capital, the $15 million of annual monitoring and alignment cost prevents about $20 million of annual value loss, and the net benefit to shareholders is $5 million a year plus the recovered capital. If they fail, shareholders bear both the monitoring cost and the residual loss.
Agency cost of debt example: a company with $200 million of debt pays 7% because of covenant-light terms and lender uncertainty. With tighter covenants, quarterly reporting and security, lenders offer 6%. The $2 million a year of interest saved is an agency cost of debt reduced through bonding; the company weighs it against the constraints the covenants impose.Case study
Seen in the real world.
A listed engineering group had been run for twelve years by a chief executive who had built it through acquisitions from $300 million to $2 billion of revenue. Return on capital had fallen every year for eight years and stood at 6%, below the company's 9% cost of capital, yet the chief executive's pay had risen with the size of the business and his bonus targets were based on revenue and earnings per share, both of which grew with every acquisition. An institutional shareholder commissioned an analysis showing that the group's shareholders would have been $700 million better off had the company simply returned its acquisition spending as dividends.
The shareholder proposed, and won, changes to the remuneration policy tying incentives to return on capital and total shareholder return, the appointment of two independent directors with capital allocation experience, and a policy of returning surplus cash. The chief executive retired within a year.
His successor sold four businesses, returned $500 million, and lifted return on capital to 11% over three years. The shareholder's report described the previous decade as "a textbook agency cost, paid in full by the owners".
Watch out
Common mistakes.
- Assuming managers are either fully aligned or fully self-interested. The reality is a gap that varies with incentives, culture and oversight, and governance is about narrowing it.
- Designing incentives around a single metric. Managers will hit the metric, and the agency problem moves to whatever it does not measure.
- Adding monitoring without weighing its cost. Governance that costs more than the losses it prevents is itself an agency cost.
Questions
People also ask.
What are the main types of agency costs?
Monitoring costs (oversight of the agent), bonding costs (constraints the agent accepts), and residual loss (value lost despite both).
How do share options reduce agency costs?
By giving managers a stake in the share price, so that decisions that benefit shareholders benefit them too. Poorly designed options can also encourage excessive risk or short-term manipulation.
What is the agency cost of debt?
The cost lenders impose, through higher rates, covenants and monitoring, to protect themselves against shareholders acting at their expense after the loan is made.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%