Agency Costs
Categories: Incorporation, Board of Directors, Investing
Think: "How much does it cost to agent this project from start to finish and then manage it?"
The people who run a company don't always own it. Usually, when we think of businesses, we imagine either tech geniuses building prototype devices in their garages and dorm rooms, or small, family-owned ventures, things like restaurants or convenience stores or funeral homes. (Not everyone thinks of funeral homes? Maybe it's time to see the therapist twice a week.)
Anyway, in both the tech genius/inventor and hard-earned small business cases, the owners run the business, so feel the impact of every financial decision. Large businesses typically aren't run the same way. In a large company, like those that trade shares on Wall Street, the people running the business don't own it, or at least don't own the largest part of it.
Most of the time, the fact that one group of people runs the business and another group of people owns the business doesn't matter. In general, everyone wants the business to do well. Most of the time, everyone's interests line up. Most of the time.
There are instances where these interests don't line up, where little cracks form in the system, where the desires of management and the goals of shareholders don't march in lock step. These situations are called "agency costs."
The "agency" part comes from the fact that the managers are acting as agents for the owners, but aren't the owners themselves. The "cost" part comes because these circumstances tend to cost the company money.
Think about business trips. It is in the shareholders' best interest to keep costs as low as possible. Managers should share rooms at some budget motel down the highway, split the free continental breakfast and pay for their own lunch. However, it is in the managers' best interest for each of them to get their own suite at a luxury hotel and approve massive per diems, so they can eat lobster and truffle-infused black rhino at every meal.
From the manager point of view, the company's money isn't their money, so spending it on perks is nothing but (black rhino) gravy for them. From the shareholder perspective, these expenses are just waste.
