Financial Management Mini Case

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Table of Contents

Introduction
Agency Costs: Agency Cost of Debt
Corporate Governance
Stock Option Compensation Plan
How Regulatory Agencies and Legal Systems Affect Corporate Governance
References

Introduction

Agency relationship refers to an agreement act between two parties, the principal and an agent. In the relationship, the principal assigns the agent tasks to perform on their behalf. From a financial management perspective, the principal can be the company stakeholders, while the agent is a manager the company has employed to run daily operations on their behalf (Panda & Leepsa, 2017). As the sole employee of the organization and also the only investor in the company, there would be no agency conflicts. There are only two possible scenarios where agency conflict may occur.

Firstly, there has to be an agent acting on behalf of the principal. Secondly, the interests of the principal and the agent must be different. Typically, the principals may be interested in better performance and share prices, while the agent is interested in compensation, power, or promotion (Panda & Leepsa, 2017). At the beginning of operating my company, there is no agent running company tasks on my behalf because I do it by myself. In turn, all my interests in the company are aligned with my desires and do not conflict with those of any agents or principals.

Agency Costs: Agency Cost of Debt

Agency costs refer to the costs due to conflicting interests between the principals and the agent. In most cases, there may be conflicting interests because the agent has more information and fewer incentives in the company compared to the stakeholders. Agency costs result when the agent makes decisions that are not in the best interests of the principals or when the principals prevent the agent from prioritizing their interests over that of the principals (Panda & Leepsa, 2017). Raising funds from outside lenders would create debt-holder relations with the company. In the most likely scenario, the debt-holders may act as the principal and I, the agent.

Similarly, in this case, the agency cost of debt may occur due to the nature of the relationship between the debtholders and the company management. In an unlikely case, the management (myself) may undertake risky decisions such as going public with an IPO, which would probably benefit the stakeholders (myself) than them. To mitigate these costs, the lenders may seek to regulate how their money is used through constraints. One of the common constraints is the debt covenants, where the lender restricts the expenditure actions of the borrower.

Corporate Governance

Corporate governance refers to a set of mechanisms by which a company is run and managed and includes the interaction among key participants to shape the performance and progress of the company. These participants may include shareholders, the management team, and the board of directors. Interactions include how the various parties interested in the company make and implement effective strategic decisions. On the other hand, performance and progress may include creating a balance between the economic and societal goals of the company. The five internal corporate governance provisions that are under an organization’s control include:

Providing funding for a project or initiative being run by the company.
Repaying company loans, debts, and balances within the set periods.
Attracting and retaining the best management talent to ensure smooth and organized operation of the company.
Meeting shareholder expectations and objectives considering their importance to the welfare of the company.
Planning both short and long-term moves with the growth and prosperity of the company in mind.

Stock Option Compensation Plan

Stock option compensation is when an employee is rewarded with a predetermined number of shares bearing a set price instead of cash or other forms of payments. Accordingly, this option is common in startups that may not have enough cash on hand to competitively pay their best employees. In this option, the awarded stock is put under a defined vesting period after which the employee can collect and sell it. Incentive stock options (ISOs) are exclusively offered to employees and bear certain tax advantages compared to non-qualified stock options (NSOs). For instance, an employee can be offered a set number of shares at $20 per share, each vesting 30% for three years. Before the expiry time, the employee pays $20 for each share, regardless of the stock price changes during this period.

Additionally, there are various problems associated with the use of stock as a compensation option, both for the company and the employee. Firstly, unless an employee is offered an ISO, stock compensation options can bear complicated tax implications for the employee. The employee may be implicated in several tax regulations, including fiduciary tax, registration and expense costs and treatment, and deductibility of tax. Secondly, the shareholder may be affected by the dilution of their shares in the long term. With the maturity of their compensations, the shareholder may dilute a certain percentage of the shares with the company. Thirdly, both the company and employee/shareholder may find it difficult to value the share options. Unless the compensation is performance-based, stock options do not factor in the performances of the employee/executive and may reward them despite poor business outcomes. Finally, the employee will have to rely on the collective performance or output of other employees to earn bonuses accrued to their stock compensations. In a typical scenario, the employee under stock compensation does not have control over the bonuses.

How Regulatory Agencies and Legal Systems Affect Corporate Governance

Corporate governance relates to how the input of various parties interested in the organization works to ensure its performance. On the other hand, regulatory agencies and legal systems determine the degree of protection of shareholder and societal rights. Typically, their role is to ensure that organizations do not engage in malpractices and manipulation of stakeholders. Various studies have determined that shareholder protection and stock market liquidity are closely related and influenced by the availability of regulatory agencies and legal systems. Stock market liquidity refers to the rate of stock turnover and indicates the performance and profitability of organizations. For example, countries that have implemented strong legal and regulatory frameworks for the protection of the rights of shareholders enjoy highly liquidity stock markets. Those with weaker frameworks have low liquidity and unattractive stock markets.

Based on the highlighted relationship, the presence of regulatory agencies and legal systems ensures robust shareholder protection rights. In turn, the management of the organization is more transparent and effective and avoids making decisions that are inclined toward their own interests. Overall, these actions increase the quality of both internal and corporate governance. In such cases, this outcome is manifested by high stock market liquidity. On the other hand, the lack of regulatory agencies and legal systems implies more conflict between the principals and the agent. More conflicts where decision-making is self-centered may translate to poor internal and corporate governance.

References

Panda, B., & Leepsa, N. (2017). Agency theory: Review of theory and evidence on problems and perspectives. Indian Journal of Corporate Governance, 10(1), 74-95.

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Financial Management Mini Case

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