How can basic differences in interest and objectives be solved? Potential problems between owners and managers

With special attention to share-ownership programms

Essay 2008 14 Pages

Business economics - Business Management, Corporate Governance


Table of Content

Table of Figures


1. Introduction

2. Principal-Agent Theory

3. Solving the Principal-Agent Problem
3.1. Mechanisms to align the interests of the Principal and the Agent
3.2. Shared-Ownership Programmes

4. Summary and Conclusions


Textbooks / Handbooks / Encyclopaedias

Journal Articles


Table of Figures

Figure 1: Top Ten – Highest Earning Managers of the DAX in 2006

Figure 2: Basic idea of Agency Theory

Figure 3: The potential elements of payment

Figure 4: Types of Financial Participation

Figure 5: Opinions on the possible merits of Share Ownership Schemes in General


illustration not visible in this excerpt

1. Introduction

A recent study of Kienbaum Human Resource Consultancy analysed the development of sal- ary increases of Top Managers in the past 30 year. (Author unknown, 20071, p.23). The result: The income of Top Managers in the 100 biggest German stock companies increased on aver- age from 1976 till 2005 from € 225,000 to € 1,8 millions, representing a compound annual growth rate of 7.45%.

Figure 1 is illustrating the annual income and its composition of the ten highest earning CEOs from German DAX companies in 2006, ranging from € 13.6 million, down to € 5.1 million.

illustration not visible in this excerpt

Figure 1: Top Ten – Highest Earning Managers of the DAX in 2006

(own illustration, Data taken from Klesse, H.J., Voss, O. (2007, p.80)

Salaries like the ones from the previous illustration, as well as big premium packages are worldwide a subject of criticism among investors. Even in the United States, some of the so- called “Fat Cats” are already seen as shysters (Eberle, M. Heilmann, D. Fockenbrock, D., 2007, p.15). Being rich and having a high income is part of the American Dream and as such not a big subject of jealousy. However, the Americans do also appreciate fairness, which is the reason why many Americans react allergically to such high incomes, especially when they assume, that the income doesn’t match with achievements of those receiving the money. Un- der consideration of the accounting scandals in the previous years (e.g. Enron), high rates of unemployment and poor wage agreements, the income level of top managers has to become in line with their achievements and results (Riecke, T. 2007, p.2).

The present assignment will discuss the potential problems between owners and managers of organisation and how gaps between the specific interests can be closed. The following part will lay the theoretical foundation, by highlighting the Principal-Agent Theory. Part three of this assignment will evaluate approaches of how the already mentioned gap can be closed. By doing so, special attention will be paid to share-ownership programmes. Finally, the author of this assignment will summarise the findings and draw his conclusions.

2. Principal-Agent Theory

Meanwhile, the principal-agent theory has become an inherent part of micro-economics and as such has found its way into educational books. Nevertheless, the following description of the principal-agent theory is comparatively detailed in order to lay the foundation for the forthcoming discussion of possible solutions concerning this problem.

A “classic” definition of the principal-agent relationship is given by Jensen, Meckling (1976, p.308). They describe the agency-relationship as

“a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent”.(Jensen, Meckling, 2007)

Following this definition, the relationship between principal and agent is a basic form of the cooperation of economic groups with self-interested, divergent objectives, imperfect informa- tion and moral in an economy, characterised by division of labour (Kaas, 1992, p. 888). An agent (A) is working on behalf of a principal (P). The principal depends on the activities, ef- forts and achievements of the agent. Hence, he pays to the agent a compensation for his ef- forts if he is successful and acts in his interests. The basic ideas of the principal agent-theory are summarised in the following illustration:

illustration not visible in this excerpt

Figure 2: Basic idea of Agency Theory

(WIKIPEDIA, 20071, http://en.wikipedia.org/wiki/Principal-agent_problem

Besides the basic case as described above, it can be the case that an agent is acting on behalf of more than one principal (e.g. a commercial representative), or other way round, that a prin- cipal is cooperating with more than one agent. The latter is the case of a line manager, having more than one employee in his team. Generally, leading back to the statements in the intro- duction, the principal agent problem is found when stockholders hire top executives for cor- porations (WIKIPEDIA, 20071).

Following Stiglitz (1989, p. 245), the key question in a Principal-Agent Relationship is the level of compensation that the agent should receive and to which parameters or variables the remuneration should be linked. The remuneration, which level can only be up to variables and which has to be observable for the principal and the agent has - on principle - the following functions:


The remuneration should be attractive in order to encourage the agent to act for the principal.


The remuneration should motivate the agent to get involved into the activities and to stand up for the interests of the principal.

3.Risk sharing

If the risk is only on the side of the agent, the agent will refuse to work for the princi- pal. On the other hand, if the risk is only on the side of the principal, there is no incen- tive for the agent to work hard in order to achieve the objective.

If an agent acts in the best possible way on behalf of the principal without any supervision and by this achieves the objective(s) of the principal, it is called an efficient principal-agent relationship (Bowie, Freeman, 1992, p. 16). However, such kind of efficient relationship doesn’t come from nothing. Pratt and Zeckhauser (1991, p.5) highlight, that “we cannot ex- pect any business enterprise or business institution to function as well as it would if all infor- mation are costlessly shared or if the incentives of principal and agent(s) could costlessly aligned”.

The costs as the result of the difference between the perfect and the real cooperation are de- fined as “agency-costs” (Brealey, Myers, 2003, p.8). Hence, within the design of a principal- agent relationship by selecting from the choice of possible settings, the main objective has to be the minimisation of the arising agency costs.



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Share-Ownership Principal Agent Theory



Title: How can basic differences in interest and objectives be solved? Potential problems between owners and managers