Agency Cost

In a company, shareholders are the principals and managers are their agents. Managers may sometimes act in their own interest rather than the shareholders', for example by pursuing expensive acquisitions to build a larger empire, taking excessive perks or avoiding risky but valuable projects to protect their jobs.

Agency costs include the loss of value from such decisions, and the costs of trying to prevent them, such as audits, board oversight, monitoring and performance-related pay. They also include bonding costs, such as managers accepting contracts that tie their pay to performance.

Conflicts can also arise between shareholders and lenders. For example, shareholders of a struggling company may prefer very risky projects, since they gain if the gamble succeeds while lenders bear much of the loss if it fails.

Agency costs were formalised in a well-known 1976 paper by Michael Jensen and William Meckling. Ways to reduce them include linking executive pay to long-term performance, independent boards, active shareholders, loan covenants and, some argue, debt itself, which limits the free cash available to managers.