Agency Theory

The agency theory states that the agent (managers) do not always act in the best interest of the principal (stockholders or shareholders). The agent is distracted by his own self interest. However, the principal could devise a contract or compensation scheme for the agent in such a way that the self interest of the agent converge with the interest of the principal.

The Principal − Agent Problem

In the corporate world, principal appoints agent to manage the business. The principal compensates the agent for performing certain acts that are useful to the principal. Because usually the agent’'s interest is not the same as the principal’s interest, the principal will structure the agent’s compensation in such a way that the agent’s interest converge with the principal’s interest. This will motivate the agent to act in the best interest of the principal.

There is information asymmetry between the principal and the agent. Because the agent is closer to the business and runs the business therefore the agent has more information about the business than the principal. If the compensation scheme is not properly structured, this may also create a conflict of interest between the principal and the agent.

For example, if the agent’s compensation is based on the growth or the sales of the company, then the agent will be motivated to increase sales. The agent could loosen credit controls hence increasing the risk of doubtful debt, reduce selling price to boost sales hence decreasing profitability of the company, and spend lots of money on marketing and advertising to capture insignificant market share and so on. All these are conflicting with the principal's interest which is to maximize profit but the agent's interest is to maximize sales hence higher compensation for himself.

If the agent's compensation is based on the profitability of the company, then the agent could be motivated to resort to dubious accounting treatments to artificially increase the company's profits. It is difficult for the principals to detect these irregularities because the principal has less information than the agent.

It is therefore important to analyze the management before you invest in a company. By understanding the management and the potential conflicts of interest that might exist, you will be able to spot a management team who can steer the business to greater heights and avoid a management team who are engrossed in their own schemes.