Post No.: 0793
Furrywisepuppy says:
Within businesses, ‘principal-agent agency costs’ can arise from the actions of an agent (e.g. senior management) when acting on behalf of a principal (e.g. the shareholders). Conflicts of interest can mean, for example, senior staff unnecessarily book the most expensive hotels or restaurants for business meetings when these costs to the business provide no added value to its shareholders.
These agency costs are inevitable whenever a business is organised under a hierarchy, especially the larger an organisation becomes. But shared reputational mechanisms and trust (e.g. if a subcontractor reneges on their agreement then it’ll directly reflect badly on them and affect any potential future business with them) can produce good institutional outcomes absent of the ability to monitor these agents or when there’s informational uncertainty because the principal doesn’t know exactly what the agent is doing because they cannot see them.
Still, who monitors the CEOs, senior managers and board of directors? Who supervises the supervisors? How do we monitor these personnel to minimise the agency costs here since they cannot be easily subjected to internal controls because ‘they’re the boss’?
A typical answer is to compensate senior managers with the company’s stock options – hence aligning the interests of raising shareholder value for the shareholders with the senior manager’s own interests of building a lucrative stock option for themselves when the time comes when they can vest them i.e. they are shareholders themselves.
It’s believed that the share price, which is governed by the external market, will help minimise the agency costs of senior managers as it’ll help align their personal interests with the firm’s. So if senior management does well then the market will signal this via the company’s share price.
However, the focus on appeasing the shareholders can mean that short-term interests and short-term profits override the long-term interests and sustained profitability of the business. The owners of a furry firm are the firm itself – it’s not really its shareholders. This is because of limited liability (which is good for the shareholders if the firm goes bankrupt and owes debt or if someone is suing the firm for a mistake that the firm committed). A shareholder’s rights depend entirely upon the contract agreed when purchasing those shares (e.g. voting rights). The fiduciary duties owed to a company’s shareholders are not sacrosanct; absent of a special agreement. The obligation of a firm ought to be really understood to be to itself, and therefore the purpose of a firm is not really to serve its shareholders and is not necessarily linked to its share value, but to ensure its own profitability so that the firm can continue to exist indefinitely; which requires investment in the long-term development of its resources and projects.
The strategy of maximising shareholder value has placed pressures for firms to use tactics that maximise the short-term results that are preferred by modern shareholders, who’ll sell their shares the moment the share price doesn’t look like it’s going to go up – modern institutional investing is a series of short-term investments that you may or may not choose to renew. Hence a firm that has an interest in maximising the short-term value for its shareholders can end up conflicting in its interest in surviving or building for the greater long-term.
A firm will respond by doing whatever it takes to continually uphold shareholder confidence and get that shareholder investment renewed – hence a ‘market of expectations’ develops i.e. manage earnings and show the market what it wants to see; even if it’s just an illusion. Meet the quarterly expectations of the market – even if this means sacrificing future and sustainable value or forgoing the best strategic choices and investments for the long-term.
Because of creative accounting, press hype and other short-term tactics that can be deployed to superficially signal a healthy company status – a firm’s share price doesn’t always reflect that firm’s genuine performance.
And with stock options, a CEO’s interests aren’t actually always aligned with the company’s because he/she could have his/her own exit strategy i.e. by doing things that artificially boost the company’s profits for the quarter (like firing employees to save wage costs), just so that he/she can sell his/her stocks in the near term or when he/she is just about to exercise those options.
A CEO’s prestige and compensation package is typically more related to the size of the company rather than its profitability, hence he/she may aim to rapidly expand despite enormous risk to the company too.
It’s tacit that it’s the shareholders who indirectly or directly agree on the compensation packages of CEOs and the elections/sackings of the board of directors, who in turn select the senior management team. (It’s similar to a representative democracy when it comes to politics.) But the fact is most shareholders never bother to utilise their voting rights. Besides, 90% of all shares in Anglo-American firms are controlled by other wealthy individuals or financial institutions; plus there may be cronyism at play, hence the senior staff at even failing firms tend to remain because they’re each other’s friends. Meanwhile, the interests of other, long-term, stakeholders (e.g. clients, employees, suppliers, communities, the government, the environment) are made subsidiary to the interests of shareholders. It’d for example arguably be better for the overall economy for companies to pay their employees better than use their profits to please shareholders via dividends, as this will benefit more of the population.
So by focusing strategies from securing long-term profitability to making more immediate returns, this can threaten the sustainability and thus long-term survival of the firm itself. These problems affect publicly traded companies more than private companies. What’s beneficial for those at the top may therefore not be beneficial for others below in a so-called ‘trickle-down effect’ either.
Refocusing on the topic of agency costs, many firms use a ‘forced ranking distribution system’ in order to monitor employees by promoting internal competition. But this kind of competition doesn’t encourage employees to be the best they can be – it actually normally encourages them to not be the worst, which is very different. (We see this in business reality show competitions where there’s lots of throwing others under the bus instead of lifting up one’s own game!)
Being fired carries a great risk to one’s reputation and it feels worse in pain than being the best feels in pleasure – reputations are hard to build yet can be dashed within an instant. So one will not be trying to be the best – one will just be trying to not be the worst i.e. second worst will suffice. This discourages high creativity and innovation because high creativity is inherently risky, thus if an employee takes a risk to be the best – which could turn the fortunes of a company around – it could result in the employee being the worst if their idea tanks.
Also, depending on the definition of ‘high performance’ used, it could lead to people gaming the system or trying to sabotage other employees rather than raising one’s own performance. It discourages team spirit and the economies of scale that collaboration can bring. For instance, employees aren’t going to want to share their knowledge with other employees because they’re one’s competition. They may distrust what other employees share with them anyway because they’re one’s competition.
One is safe in the middle thus the optimum strategy will be to merely do ‘just relatively enough to get by’. Mediocre is fine; no point in striving for absolute excellence, especially if one feels that one’s chances of being at the very top are low. It also discourages top talent from wanting to work together because they’ll know their competition will be riskily stiff – the rational strategy would be for a highly talented employee to want to work with relatively less talented colleagues in order to look good by comparison, thus we’ll miss out on the interactive mixing of ideas between the best workers. The efficient network effects between employees, as well as between businesses, come from people copying, collaborating and competing with each other, not just competing.
The agency costs here are every employee being focused on their own individual interests, even if this results in a sub-optimal performance for the organisation overall. Some individuals may behave differently, but in general, the above is how employees will behave. A forced ranking distribution system may work in the beginning when it genuinely gets rid of the fuzzy deadweight but it works sub-optimally after that.
In order to produce the optimal outcome and reduce agency costs – it’s best not to focus on coercive fear or punishments but on mechanisms that foster trust and a shared reputational capital amongst the employees, and to simply reward the best. This is not saying that firing isn’t still an option for any free-riders – it’s just saying that there shouldn’t be a set number of people to promote and fire each quarter (unlike in certain business reality show competitions where, no matter if the contestants all do superbly or (more often) abysmally, one team will always get rewarded and one person will always get fired, except in rare cases).
Therefore individual competition doesn’t always produce optimal results or reduce agency costs. Promoting collaboration by ensuring a mutually shared stake or interest works better.
In short, principal-agent agency problems can occur whenever you (the principal) hire someone (an agent) but are unsure whether they’ll act on behalf of your best interests or merely their own. Agency costs arise when their and your interests aren’t exactly aligned to seek the exact same outcome.
…Practices like tying a senior manager’s interests with the company’s via stock options, or using a forced ranking distribution system in order to incentivise employees to perform at their best through competition, appear, on the face of them, like perfect ways to solve agency problems. But we can see now that we mustn’t just accept the legitimacy of something simply because it is a common practice, without first examining the assumptions upon which it is based. Interrogate closely what you believe, to see whether it holds up to critical scrutiny. It’s not to necessarily say that everything you think you know is wrong – it’s saying that everything you think you know barely scratches the surface of what there is to know. And just because millions of others have thought in a certain way and have done things in a certain way – it doesn’t make it the only or the best way. No one and nothing has proven to be invincible yet – not even the biggest or supposed best!
Our biases shape how we interpret, remember and relay information. We aren’t just passively absorbing – we’re subconsciously interpreting what we hear so that it fits with our own present worldviews and culture. The stories we tell ourselves become our own truths to us, but this doesn’t make them necessarily true in reality (e.g. the scapegoats and apportioning blame, ‘project fear’ and that a risky venture isn’t risky at all, or that we know something that others don’t). The power of narratives convinces us of what we want to believe. Once we tell ourselves a story, we often don’t realise it’s just a story – stories operate as our truths unless we interrogate and question their legitimacy. Others who defer to your authority and/or follow the crowd may believe in them too, hence myths and legends can spread via groupthink.
So don’t accept a particular management practice simply because it represents an orthodox way of thinking. You’ll need to employ all of the analytical flexibility and strategic latitude that you can. Be a good Socratic manager. Stay inquisitive. Periodically question your own beliefs no matter how steady or long-standing they’ve been. No matter how good you’ve been – never think you know it all and never stop asking questions.
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