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We've seen that the financial manager in a corporation acts in the best interests of the stockholders by taking actions that increase the value of the firm's stock. However, we've also seen that in large corporations ownership can be spread over a huge number of stockholders. This dispersion of ownership arguably means that management effectively controls the firm. In this case, will management necessarily act in the best interests of the stockholders? Put another way, might not management pursue its own goals at the stockholders' expense? We briefly consider some of the arguments below. Agency RelationshipsThe relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interest. For example, you might hire someone (an agent) to sell a car that you own while you are away at school. In all such relationships, there is a possibility of conflict of interest between the principal and the agent. Such a conflict is called an agency problemThe possibility of conflict of interest between the owners and management of a firm.. Suppose you hire someone to sell your car and you agree to pay her a flat fee when she sells the car. The agent's incentive in this case is to make the sale, not necessarily to get you the best price. If you paid a commission of, say, 10 percent of the sales price instead of a flat fee, then this problem might not exist. This example illustrates that the way an agent is compensated is one factor that affects agency problems. Management GoalsTo see how management and stockholder interests might differ, imagine that a corporation is considering a new investment. The new investment is expected to favorably impact the stock price, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the share value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost. It is sometimes argued that, left to themselves, managers would tend to maximize the amount of resources over which they have control, or, more generally, business power or wealth. This goal could lead to an overemphasis on business size or growth. For example, cases where management is accused of overpaying to buy another company just to increase the size of the business or to demonstrate corporate power are not uncommon. Obviously, if overpayment does take place, such a purchase does not benefit the owners of the purchasing company. Our discussion indicates that management may tend to overemphasize organizational survival to protect job security. Also, management may dislike outside interference, so independence and corporate self-sufficiency may be important goals. Do Managers Act in the Stockholders' Interests?Whether managers will, in fact, act in the best interests of stockholders depends on two factors. First, how closely are management goals aligned with stockholder goals? This question relates to the way managers are compensated. Second, can management be replaced if they do not pursue stockholder goals? This issue relates to control of the firm. As we will discuss, there are a number of reasons to think that, even in the largest firms, management has a significant incentive to act in the interests of stockholders. Managerial Compensation Management will frequently have a significant economic incentive to increase share value for two reasons. First, managerial compensation, particularly at the top, is usually tied to financial performance in general and oftentimes to share value in particular. For example, managers are frequently given the option to buy stock at a fixed price. The more the stock is worth, the more valuable is this option. The second incentive managers have relates to job prospects. Better performers within the firm will tend to get promoted. More generally, those managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries. In fact, managers who are successful in pursuing stockholder goals can reap enormous rewards. For example, Rueben Mark, CEO of consumer products maker Colgate-Palmolive, received about $148 million in 2004 alone, which is less than Mel Gibson ($210 million), but way more than Beyoncé Knowles ($21 million). For the five-year period ending 2004, Larry Ellison of software giant Oracle was one of the top earners, receiving over $835 million. Control of the Firm Control of the firm ultimately rests with stockholders. They elect the board of directors, who, in turn, hires and fires management. The mechanism by which unhappy stockholders can act to replace existing management is called a proxy fight. A proxy is the authority to vote someone else's stock. A proxy fight develops when a group solicits proxies in order to replace the existing board, and thereby replace existing management. Another way that management can be replaced is by takeover. Those firms that are poorly managed are more attractive as acquisitions than well-managed firms because a greater profit potential exists. Thus, avoiding a takeover by another firm gives management another incentive to act in the stockholders' interests. Information on executive compensation, along with a ton of other information, can be easily found on the Web for almost any public company. Our nearby Work the Web box shows you how to get started. Sometimes it's hard to tell if a company's management is really acting in the shareholders' best interests. Consider the 2005 merger of software giants Oracle and PeopleSoft. PeopleSoft repeatedly rejected offers by Oracle to purchase the company. In November 2004, the board rejected a "best and final" offer, even after 61 percent of PeopleSoft's shareholders voted in favor of it. So was the board really acting in shareholders' best interests? At first, it may not have looked like it, but Oracle then increased its offer price by $2 per share, which the board accepted. So, by holding out, PeopleSoft's management got a much better price for its shareholders. Conclusion The available theory and evidence are consistent with the view that stockholders control the firm and that stockholder wealth maximization is the relevant goal of the corporation. Even so, there will undoubtedly be times when management goals are pursued at the expense of the stockholders, at least temporarily.
Agency problems are not unique to corporations; they exist whenever there is a separation of ownership and management. This separation is most pronounced in corporations, but it certainly exists in partnerships and proprietorships as well. StakeholdersOur discussion thus far implies that management and stockholders are the only parties with an interest in the firm's decisions. This is an oversimplification, of course. Employees, customers, suppliers, and even the government all have a financial interest in the firm. These various groups are called stakeholdersSomeone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm. in the firm. In general, a stakeholder is someone other than a stockholder or creditor who potentially has a claim on the cash flows of the firm. Such groups will also attempt to exert control over the firm, perhaps to the detriment of the owners.
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