Starting a business often requires one to understand the particulars of an agency relationship and the conflicts of interest that may arise in the course of expanding one’s business. The agency relationship describes the relationship where one person (the principal) contracts another (agent) to act on their behalf for the achievement of certain business objectives. The agency relationship normally occurs smoothly until there is a conflict of interest between the needs of the principal and those of the agent (Koh, Ang, Brigham, & Ehrhardt, 2014). In this paper, the agency relationship for a startup entrepreneur is considered in light of his objectives to start a company which will enable him to pursue his dreams of underwater photography. Different scenarios are contemplated to determine whether agency problems exist for each of them.
Single Employee Company
At the beginning of the business, there will be only one employee who acts in the capacity of both stockholder and manager. In such a case, there will be no agency problem between stockholders and managers since their interests are aligned. The fact that the manager is also the stockholder means that the company will be directed in a hitch-free manner that suits both the management and stockholders. However, there could exist a potential agency problem between the stockholder and the creditors due to the debt question. The manager could obtain debt that would finance the business for the initial part of the year, but which will affect the future cash flows for the business, thereby creating a possible dilemma situation for the stockholder.
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Additional Employees Company
When additional employees come onboard, the management and the stockholders are no longer the same individual. In fact, there is likely to be agency problems. This is because there is potential for the interests of stockholders to go against those of the management. For instance, the management might choose to grow the company to avoid a takeover whereas a takeover might be in the interests of the stockholders. With added employees, there is a certain level of risk that is added to the company. Another agency problem could arise with the creditors, where the riskiness of the company will determine their ability to lend to the company, thereby affecting future cash flows.
Selling Stock
Where additional capital is sought so that stock is sold to outside investors thereby maintaining majority control of the company, an agency problem with the creditor is likely to occur. Creditors often loan money to companies based on their capital structures and riskiness. These factors are determined by the stockholders so that they will normally make these decisions based on their best interests.
Agency Costs
These are costs arising due to the agent’s activity on behalf of the principal. In the case where the agent obtains funds from outside lenders, different agency costs might be present including reduced stock value and the provision of proper incentives such as bonuses and stock options. Obtaining money from outside lenders often includes some kind of deal which will come at a detriment to the principal.
Managerial Habits that Harm Value
Where there is relative success for the operation of the company after paying off the majority of the debt, there are practices that could lead to decreasing firm value. These actions are listed below:
Avoiding to make the tough decisions.
Avoid repaying investors by making excessive investments or acquisitions.
Manage earnings to avoid releasing bad news.
Expend little effort and time.
Consume excess non-pecuniary benefits, and
Reject risky positive NPVs to maintain stability or take long shots to make home-run profits.
Corporate Governance
Corporate governance suggests a system of rules through which a firm is controlled and directed (Koh, Ang, Brigham, & Ehrhardt, 2014). According to Koh et al. (2014), five facets remain under the management’s control when it comes to corporate governance, including: discipline from the board of directors, compensation planning, accounting controls, capital structures and charter provisions providing for hostile takeovers.
Characteristics of Effective Boards
One characteristic is that the CEO is not the chairman of the board, thereby removing all undue influence from the decision-making processes of the board. The board must also consist of outsiders with business expertise. Such boards should also not be too large, with each member being compensated appropriately. In this way, the board provides value to the company.
Provisions affecting Hostile Takeovers
Provisions include share repurchases, restricted voting rights and poison pills, which are provisions for shareholder rights.
Problems with Using Stock Options as Compensation
Using stock options normally indicates a fixed price on the stock regardless of whether the market price is higher. Furthermore, stockholders compensated in this manner still receive handsome compensation despite poor company performance. Finally, the company can be tempted to dress results to prepare for the release of financial statements.
Block Ownership and Corporate Governance
Block ownership occurs when an outside entity owns the larger part of company share. Block ownership thus has complete outsider control on the company, where decision-making is affected by his majority voting capability. However, it is also possible that block owners maintain checks on the management, thereby offering high quality corporate governance.
Regulatory Agencies, Legal Systems and Corporate Governance
Corporate governance is affected by compliance to legal requirements from both systems and regulatory agencies in place. Compliance to these systems is important in protecting minority stockholders from being exploited by majority stockholders. Moreover, these systems provide avenues through which companies can raise equity swiftly, as required.
References
Koh, A., Ang, S. K., Brigham, E. F., & Ehrhardt, M. C. (2014). Financial management: theory and practice. New York: Cengage Learning.
