How to Reduce Agency Conflicts Between Stockholders and Bondholders

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Bondholders and shareholders represent two factions of a company's capital structure with somewhat opposing interests. Bondholders are the creditors of the company and receive first consideration over the company's assets in a corporate liquidation. Shareholders receive last consideration in corporation liquidation, often receiving nothing for their shares. However, a shareholder has unlimited upside on his investment. If a risky project turns out profitable, only shareholders benefit. However, bondholders want to avoid risk. Instituting debt covenants is one way to reduce agency conflicts between bondholders and shareholders who both share financial risk.

Hold a board meeting with bondholder and shareholder representatives. Decide which debt covenants to create and put the matter to a vote. In general, covenants should prevent a company from taking on too much debt, thereby reducing the financial risk to the firm, which benefits bondholders and shareholders.

Institute debt covenants. The most basic debt covenant protects current bondholders. It also protects shareholders since larger interest payments mean less net income available to shareholders. For example, a typical covenant may require a company to maintain a specific debt-to-equity ratio, debt-to-asset ratio or interest coverage ratio (earnings before interest and taxes, or EBIT, divided by interest expense).

Create a sinking fund that allows the company to reduce its debt level as agreed by bondholders and shareholders on a specified schedule. A sinking fund is money set aside to retire the company's indebtedness. For example, the company may purchase a portion of its outstanding bonds in the open market.

Tips

  • Another option is offering bondholders the opportunity to participate in the fortunes of the company, particularly if the company is extremely profitable. Companies with strong growth prospects tend to favor issuing debt over issuing new shares to avoid dilution of shareholder equity. A company may offer convertible bonds that allow a bondholder to convert his debt interest into company stock. In this way, the convertible bond serves to bring the interests of bondholders and shareholders in line.

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