Question

c. Explain how you might be able to use a compensation plan that limits the potential agency problems?

Answer 1

In businesses, agency problems occur between the stockholders (principal) and corporate managers (agents). While the stockholders appoint the managers to take care of the company but the managers may look into their own desires first. The primary goal of a corporation is the maximize shareholder’s wealth and value creation. A firm’s value can be maximized if its expected benefits are maximized in the long-run while profit maximization is relatively for short term.

Employee stock options with some initial lock-in period can be used as a compensation plan that limits the potential agency problems. It will encourage the managers to work in long term interest of the company. The good performance of the organization will finally reflect in the shares of the company and it will benefit the stock holders of the company. It will also benefit the managers of the company because value of the Employee stock options will increase and managers will get extra compensation for their good performance.