Question

Explain several dimensions of the shareholder-principal conflict with manager-agents known as the principle-agent problem. To mitigate agency problems between senior executives and shareholders, should the compensation committee of the board devote more to executive salary and bonus (cash compensation) or more to long-term incentives? Why? What role does each type of pay play in motivating managers?

Answer 1

Answer 2

The principal-agent problem, also known as the agency problem, refers to the conflict of interest that arises between shareholders (principals) and managers (agents) of a company. This conflict occurs because managers may prioritize their own interests over those of the shareholders, leading to a divergence in goals and potential loss of shareholder value. Several dimensions of this conflict can be identified:

1. Risk and Effort: Shareholders desire managers to take on projects and make decisions that maximize the long-term value of the company. However, managers may have a preference for lower-risk strategies that ensure their job security or may not exert maximum effort in pursuing the company's goals.

2. Information Asymmetry: Shareholders may not have access to complete information about the managers' actions and decision-making processes. Managers, on the other hand, possess more information, which can create opportunities for them to act in their own self-interest.

3. Monitoring and Control: Shareholders face challenges in effectively monitoring and controlling managerial behavior. They rely on mechanisms such as financial reporting, audits, and board oversight to mitigate opportunistic actions by managers. However, these mechanisms are not always foolproof and may not fully align the interests of shareholders and managers.

To mitigate agency problems between senior executives and shareholders, it is generally recommended that the compensation committee of the board devotes more attention to long-term incentives rather than focusing solely on executive salary and short-term bonuses. Here's why:

1. Alignment of Interests: Long-term incentives, such as stock options, restricted stock units, or performance-based equity grants, align the interests of executives with those of shareholders. These incentives motivate executives to focus on actions and decisions that drive long-term value creation, as their financial rewards are tied to the company's sustained performance.

2. Risk Management: Cash compensation, such as salary and short-term bonuses, primarily provide immediate rewards to executives. While necessary to attract and retain talent, excessive reliance on cash compensation may encourage short-term thinking and excessive risk-taking, as executives may prioritize maximizing their bonuses in the short term without considering the long-term consequences.

3. Performance Evaluation: Long-term incentives enable a more comprehensive evaluation of executive performance over a longer time horizon. They incentivize executives to pursue sustainable growth strategies and make decisions that enhance shareholder value in the long run. On the other hand, short-term bonuses may incentivize executives to focus on achieving short-term targets without sufficient consideration for the long-term implications.

In summary, long-term incentives play a crucial role in mitigating agency problems between senior executives and shareholders. They align the interests of executives with those of shareholders, promote long-term thinking, and provide a more accurate assessment of executive performance. While cash compensation remains essential, an overemphasis on short-term bonuses can lead to misaligned incentives and increased agency problems.