Lesson 1 of 7 · All lessons in this module
- Principal-agent relationships and agency costsVideo lesson
- Managers versus shareholders: five ways interests diverge
- Controlling versus minority shareholders, and shareholders versus creditors
- Reporting, shareholder meetings, activism and takeovers
- Creditor protections and board committees
- Employees, customers, suppliers and governments
- Risks of weak governance and benefits of strong governance
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Lesson 1 of 7 · 12 min
Principal-agent relationships and agency costs
Whenever one party hires another to act on its behalf and the hired party knows more, their interests can drift apart, and the costs of that drift (monitoring plus lost value) are agency costs that investors price into their required returns.
In short
- A principal-agent (agency) relationship exists when a principal hires an agent to perform a task; it can exist with or without a contract and rests on trust, loyalty and diligence.
- In a corporation, shareholders (principal) elect directors (agent), who hire managers (another agent) to maximise shareholder value.
- Other relationships are contractual: suppliers (sell inputs), customers (buy output), lenders (provide capital under a contract); governments oversee compliance.
- Information asymmetry: agents usually know more, so principals cannot easily verify that agents act in their interest.
- Agency costs are direct (e.g. paying an external auditor) or indirect (forgone profits from lost opportunities).
- More information asymmetry means more room for conflict, so shareholders and lenders demand higher returns and risk premiums.
Who is principal, who is agent
A company is a legal entity with many parties attached to it. Some relationships are principal-agent relationships: one party (the principal) hires another (the agent) to do a job and expects the agent to act in the principal's best interest. Such a relationship can exist with or without a formal contract; what defines it is delegation, trust and an expectation of loyalty and diligence.
The core chain is simple. Shareholders are the principal. They elect the board of directors, who act as their agent. The board in turn hires managers, a second layer of agents, whose job is to run the business so that shareholder value is maximised. Employees are hired by managers and also act as agents of the company.
Other parties have mainly contractual relationships. Suppliers sell inputs, customers buy output, and creditors provide capital, each under a contract that spells out rights and obligations. Governments sit outside the company, setting laws and overseeing compliance.
| Stakeholder | Relationship with the company | Role |
|---|---|---|
| Shareholders | Principal | Capital provider; elect the board |
| Board of directors | Agent of shareholders | Oversees and hires management |
| Managers, employees | Agents | Run the business |
| Creditors | Contractual | Capital provider under a loan or bond contract |
| Suppliers | Contractual | Sell inputs |
| Customers | Contractual | Buy output |
| Governments | Oversight | Set laws, monitor compliance |
Information asymmetry and agency costs
Agents usually hold better information than principals. Directors and managers see the company's results, risks and opportunities long before outsiders do. This information asymmetry means principals often cannot check directly whether the agent is acting in their interest, and it weakens their ability to spot and remove poor performers.
Asymmetry is greater for companies that operate in many markets and countries, sell complex products, or have little institutional ownership and a small free float (few shares freely traded), because fewer informed outsiders are watching.
When the interests of principal and agent diverge, the result is an agency cost. Direct agency costs are amounts spent on monitoring, such as the board hiring an external auditor (audit fees are paid by the company, so ultimately by shareholders). Indirect agency costs are the forgone profits and benefits of opportunities that were lost because the agent acted in its own interest.
- Direct: audit fees, independent directors' fees, investigation and monitoring costs.
- Indirect: value lost from a good project the managers skipped, or a bad acquisition they made.
Why investors charge for asymmetry
Shareholders and lenders know that the less they can see, the more room agents have to act against them. They respond by demanding a higher return and risk premium: a lower share price (lower valuation multiple) for equity and a higher yield on debt.
So information asymmetry is not just a fairness issue; it raises the company's cost of capital. Much of corporate governance is about cutting this asymmetry and aligning agents with principals, which the later lessons cover.
Suppliers and customers are also outsiders with less information, but their relationship is contractual and not based on an investment return, so the 'higher required return' effect is about capital providers.
Worked examples
Example 1 Classifying relationships
Nordhavn Foods ASA has shareholders, a board, a CEO, a bank loan, a packaging supplier and supermarket customers. Classify each relationship with the company and say where agency conflicts are most relevant.
Example 2 Direct or indirect agency cost?
Last year Calder Holdings plc paid GBP 1.2 million in external audit fees and GBP 0.6 million to an independent consultant hired by the board to review a large contract. Its managers also turned down a project with expected value added of GBP 5 million because it might expose their weak cost control. Classify and total the direct agency costs.
On the exam
Expect items asking who is principal versus agent (shareholders principal; board and managers agents; customers contractual), examples of direct versus indirect agency costs, and which parties demand higher returns when information asymmetry rises (shareholders and lenders).
- Calling the board the principal. Shareholders are the principal; the board is their agent.
- Classifying customers or suppliers as agents. Their relationship with the company is contractual.
- Thinking agency costs are only out-of-pocket spending. Forgone opportunities are indirect agency costs.
- Thinking suppliers and customers demand higher 'returns' when asymmetry rises. That effect is about capital providers.
Check yourself
Q1In a corporation, the board of directors is best described as:
Q2Which of the following is most likely a direct agency cost?
Q3Customers of a corporate issuer most likely have which type of relationship with it?
Q4When information asymmetry about a company increases, which groups most likely demand higher returns?
Q5Information asymmetry between insiders and outside shareholders is least likely to be high for a company that:
Answer the 5 questions: +10 XP for each one you get right first time.
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