# Agency Problem and Agency Cost
## What is the Agency Problem?
In sole proprietorships and partnerships, owners participate in management. But in corporates, owners are NOT active in management — there is a separation between owners/shareholders and managers.
- In theory, managers should act in the best interest of shareholders.
- In reality, managers may try to maximise their individual goals (salary, perks, empire-building).
- This principal-agent relationship between managers (agents) and owners (principals) is the Agency Problem.
> Agency Problem = the chance that managers may place personal goals ahead of the goal of owners.
## Agency Cost
The Agency Problem leads to Agency Cost — the additional cost borne by shareholders to monitor managers and control their behaviour to maximise shareholders' wealth.
### Four Types of Agency Cost
1. Monitoring costs
2. Bonding costs
3. Opportunity costs
4. Structuring costs
## Two Layers of Agency Conflict
| Conflict | Addressed By |
|---|---|
| Manager vs. Equity Shareholders | Align managerial pay with shareholder wealth (ESOPs, performance bonuses) |
| Manager vs. Debt Lenders | Negative covenants restricting managers from borrowing beyond a point |
## How to Address the Agency Problem
Alignment is easier said than done, but the following efforts have been made:
1. Managerial compensation linked to profit of the company (and long-term objectives).
2. Employee Stock Option Plans (ESOPs) — assuming maximisation of stock price is the investor's objective.
3. Effective monitoring by the board, auditors, and independent directors.
4. For lenders: negative covenants in loan agreements (limits on further borrowing, dividend payouts, etc.).
## Why This Matters in Modern Finance
This concept is foundational to:
- Credit Risk Management in banks
- Fund raising decisions
- Valuation of distressed companies