Agency Problem

Shareholders own the company but hire managers to run it. Managers know more about the business and may prefer pay, status, empire building or a quiet life over maximising long-term value. Agency theory studies this gap and the cost of closing it: monitoring, incentives and the losses that remain. Many governance tools exist to narrow it, including independent directors, audit, disclosure, share-based pay and shareholder voting rights. In companies with a controlling shareholder, the conflict shifts: the controller, acting as agent for all owners, may favour itself over minority holders. The same logic applies beyond companies, for example to a broker advising a client or an official serving the public. Each governance tool, from audit to share-based pay, can be read as an attempt to shrink this gap.

The managers of a mid-sized firm are paid on annual revenue, so they approve a costly acquisition that lifts sales but lowers profit. Shareholders have little information to object. The board responds by tying part of the bonus to three-year returns, adding independent directors to the audit committee and requiring shareholder approval for deals above a set size.