Question

Explain the principal-agent problem as it pertains to equity contracts.

Answer 1

The principal agent problem arises when one party ( agent) agrees to work on behalf of the another party( principal) in return for some incentives.

This can really cause a lot of disagreement between both the parties as the principal party will always want more profits to be distributed amongst themselves leaving the agent very unhappy and dissatisfied thereby leading to conflict of interest and moral hazard.The agent usually has more information than the principal. This is called asymmetric information, the difference in knowledge of both the parties. The principal will not know how the agent is going to function which may not be aligned with principal's interest. This is called the ' agency cost', moving away from the interest of the principal.

For example, incase a group of 20 people starts a company and they would be the shareholders and these group will appoint a manager to take care of their business and expects the manager to run the business and earn profits for them. Here the principal party are the shareholders and the agent is the manager. The shareholders expectation is that the manager need to distribute all the profits to them. The manager would eventually feel that his growth is curbed in terms of profit and hence will try to retain the profit for future of the company, thereby resulting in conflict of interest and principal agent problem. This is a common scenario in most of the companies which are not managed by the owners. It is the shareholders who will be holding most of the equity and the managers just a meagre portion, hence they do not have incentive to maximize profit as the shareholders. The agent will not strive towards achieving the goals of the principal, will instead pursue his own goals.