What it means
In a small business the owner is the manager, so there is no conflict. In a larger company, shareholders hire managers to run the business for them.
The managers may prefer comfort, power or short-term bonuses over the long-term value that shareholders want. This gap is called the principal-agent problem.
Economists describe three kinds of agency cost: monitoring costs, which owners bear to watch managers; bonding costs, which managers bear to show they can be trusted; and the residual loss, which is the value that remains lost even after those efforts. Together they measure the price of separating ownership from control.
Typical monitoring costs include external audits, independent directors and reporting systems. Bonding costs might include insurance, personal guarantees or contracts that restrict what managers can do.
The residual loss appears when a manager still makes a poor decision, such as overpaying for a prestige acquisition. Companies try to reduce agency costs by aligning incentives.
Giving managers shares or options ties their wealth to the company's success, and performance-based bonuses reward the outcomes owners want. Debt can also discipline managers, because required interest payments leave less free cash to spend carelessly.
Agency problems also arise between shareholders and lenders, and between majority and minority shareholders. A controlling owner may take decisions that benefit them but not smaller investors.
Good governance, transparency and strong boards help to keep all of these costs in check, although none removes them completely. Debt and dividends play a part in this story as well.
Regular loan repayments and a dividend policy force managers to hand cash back instead of keeping it for pet projects. That is why highly cash-generative companies often face pressure from shareholders to distribute surplus cash.
In practice
Real-world examples
Example 1
A shareholder group pays for a full external audit and an independent audit committee of a family-controlled retailer. The costs reassure outside investors that the owner-managers are not taking money out improperly. The retailer's shares trade at a smaller discount as a result, which lowers its cost of raising new capital.
Example 2
A chief executive of a mid-sized manufacturer pursues a large acquisition to build a bigger empire, although the deal has weak returns. The share price falls 9% after the announcement. The residual loss is the value destroyed.
Example 3
A private equity owner links the management team's bonuses to cash generation and gives them a share of any increase in value. Managers who once pushed for expansion now focus on profit. The incentive scheme costs money, but it reduces the conflict and has lifted cash generation.
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 costs = Monitoring costs + Bonding costs + Residual loss
A listed company spends $120,000 a year on external audit, independent board fees and internal reporting, which are the monitoring costs. Its managers buy $40,000 of insurance and fidelity guarantees as bonding costs. A review estimates that one poor acquisition decision destroyed $90,000 of value, which is the residual loss. Total agency costs = $120,000 + $40,000 + $90,000 = $250,000.Case study
Seen in the real world
Falconwood Industries is a fictional manufacturer that, in this illustrative story, generated surplus cash of $20,000,000 a year. The founder-turned-chairman wanted to buy a luxury head office and a corporate jet, while the investors wanted dividends.
The board hired an independent consultant to estimate the cost of this conflict. It found that previous spending on non-essential perks and low-return projects had destroyed an estimated $8,000,000 of value over three years, in addition to $500,000 a year of oversight cost.
The board introduced a policy that linked executive pay to return on capital and committed to distributing 60% of surplus cash as dividends. The share price rose as investors gained confidence that the management team was working for shareholders. The chairman agreed to publish an annual statement explaining how executive pay linked to results.
Watch out
Common mistakes
- Assuming agency costs only arise in large listed companies. They can occur in family firms, partnerships and start-ups too.
- Believing that more monitoring always solves the problem. Excessive controls cost money and can slow decisions.
- Treating bonuses as a cure-all. Poorly designed incentives can encourage short-term thinking or risk-taking.
Questions
People also ask
What is the principal-agent problem?
It arises when one party, the agent, makes decisions on behalf of another, the principal, but has different interests. Shareholders and managers are the classic example.
How can companies reduce agency costs?
They can align incentives with equity pay, use independent boards, improve transparency and use debt discipline. The best mix depends on the business.
Do agency costs appear as a line on the income statement?
Not as a single item. They are spread across audit fees, board costs, incentive schemes and the hidden loss from poor decisions.
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