Corporate management should act in the best interest of a company's stakeholders, especially the shareholders who own equity but have no direct voice. The agency theory of corporate governance is quite simple, at least on the surface. It states that corporate executives have a moral and financial duty to act in the best interests of the parties they serve, specifically the shareholders. In practice, agency theory can sometimes be quite challenging, especially when there are billions of dollars at stake.
TL;DR (Too Long; Didn't Read)
The agency theory of corporate governance addresses conflicts of interest for board members by stating that executives must prioritize the interests of shareholders.
Importance of Agency Theory
Agency theory provides clear parameters for corporate officers and board members making strategic decisions. It comes in handy if decision makers have a tendency to be greedy and profit at the expense of the company. It is also an invaluable guideline when a company's long-term interests conflict with actions that may provide lesser but more immediate benefits to stakeholders.
- Decision-making protocols. In theory, buying a share of company stock gives you a vote in major company decisions. This right is diluted by the fact that some stockholders may own a single share, giving them a single vote, while others own thousands of shares, giving them thousands of votes. Executives and board members should represent all shareholders, but they might overrepresent those who own the most equity. Agency theory is a step toward navigating these complex and sometimes conflicting obligations.
- Greedy executives. The people with the power to make high-level corporate decisions are often directly in line to benefit from some of these decisions, especially with regard to issues of corporate pay. In a perfect world, high pay and large bonuses for executives would motivate and reward them for quality work that brings in extra income for all shareholders. In the real world, high corporate pay can come at the expense of the bottom line that is divided among the broader pool of shareholders.
- Long-term vs. short-term interests. It may be in the best interests of a company to invest in the future, but these outlays often come at the expense of short-term rewards such as shareholder dividends. Executives conscientiously practicing corporate agency theory will use the knowledge and skills that landed them in management positions to make the best calls possible for the organization as a whole.
Purpose of Agency Theory
In order to explain agency theory, it's useful to think in terms of different perspectives on risk assessment. Unless shareholders are unusually well informed about the inner workings of a company, they're likely to want to invest company resources in ways that will bring the most income in the short term. However, investments that bring about quick returns tend to be riskier than strategies that unfold more slowly, allowing a company to adapt and adjust.
Shareholders purchase their shares and then enjoy returns over time if the business is successful. Although the value of their shares may be at risk from speculation and approaches geared toward reaping short-term benefits, the shareholders themselves aren't taking on any additional risks from these ventures. In contrast, managers and board members who are more actively involved in the company's day-to-day activities have a more sober assessment of the risks associated with aggressive short-term strategies.
The Importance of Communication
By keeping shareholders well informed of company activities, executives and board members who act in their interests as agents can mitigate some of the risk of distrust and conflict of interest that is often characteristic of this relationship. Transparency helps to reinforce the idea that the interests of shareholders and their management are ultimately aligned, and agents are truly acting in the best interests of the parties they represent.