Agency Costs

Key takeaways

• Agency costs arise when an agent acts on behalf of a principal and their interests diverge.
• They include expenses tied to resolving conflicts of interest and aligning incentives (often called agency risk).
• Common consequences are reduced shareholder value, management upheaval, and transaction or monitoring expenses.
• Mitigation focuses on better alignment of incentives and stronger governance and oversight.

What are agency costs?

Agency costs are internal expenses that result when one party (the agent) makes decisions on behalf of another (the principal) but pursues objectives that conflict with the principal’s interests. In corporations, this typically means costs resulting from differences between managers’ actions and shareholders’ goals.

The principal–agent relationship

The principal–agent relationship describes scenarios where one party delegates decision-making to another:
* In corporations, shareholders are the principals and managers are the agents.
* Similar dynamics can appear in other contexts (for example, voters as principals and elected officials as agents).
* When many principals exist (a “multiple-principal” situation), coordinating oversight and incentives becomes more complex.

What drives agency costs?

Agency costs stem from core inefficiencies and conflicts of interest, including:
* Managers pursuing growth, perks, or short-term gains that do not maximize shareholder value.
* Costs of monitoring and enforcing desired behavior (e.g., audits, governance processes).
* Expenses to align agent behavior with principals’ goals (performance bonuses, stock options, contractual mechanisms).
* Disputes and the transactional costs of resolving them.

These costs are sometimes referred to as agency risk—expenses associated with managing the needs and conflicts of different parties within an organization.

Consequences for shareholders and the company

• Shareholder dissatisfaction can prompt selling, potentially driving down stock prices.
• Large-scale sell-offs may deter new investors and further depress valuation.
• Shareholders may attempt to replace board members or management, which can be costly in time, money, and organizational disruption.
• Poorly aligned incentives can reduce profitability and long-term firm value.

Real-world example

The Enron scandal illustrates agency risk: senior officers and directors benefited from misleading accounting practices and sold shares at inflated prices. When the truth emerged, shareholders suffered significant losses and trust in management collapsed.

Mitigating agency costs

Organizations commonly use several tools to reduce agency costs:
* Aligning incentives through compensation design (stock options, performance-based pay).
* Strengthening board oversight and independent monitoring.
* Transparent reporting, audits, and internal controls.
* Active shareholder engagement and governance mechanisms (voting, proxy contests).

By improving alignment between agents and principals and enhancing monitoring, firms can reduce agency-related expenses and better protect shareholder value.