## Addressing the Agency Problem

### 1. Between Debt Lenders and the Company

The agency problem with debt lenders is addressed by imposing negative covenants in loan agreements:

Restrict managers from borrowing beyond a specified limit
Widely used in: credit risk management, fund raising, valuing distressed companies

### 2. Between Managers and Shareholders

Aligning the interests of managers with shareholders reduces the agency problem:

Mechanism	How It Helps
Managerial compensation linked to profits and long-term goals	Managers are rewarded for creating shareholder value
Employee Stock Options (ESOPs)	Managers become shareholders → incentivised to maximise stock price
Effective monitoring of managerial actions	Board oversight, independent directors, audits

> Key Insight: Aligning interests (incentive alignment) is more effective than just monitoring alone.

Worked example

### Example 1

A company grants ESOPs to its CFO vesting over 4 years. The CFO now has a personal financial stake in the stock price, so her decisions are more aligned with long-term shareholder value.

### Example 2

A bank loan agreement includes a negative covenant restricting the borrower from raising additional debt exceeding a debt-equity ratio of 2:1. This protects existing lenders from the company over-leveraging.

⚠️ Common exam mistakes

Thinking monitoring alone solves the agency problem — incentive alignment (ESOPs, profit-linked pay) is equally important.
Confusing negative covenants with penalties — they are contractual restrictions, not punishments.

Reference:

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