Agency risk is the amount of risk that exists within a company structure that the owners, officers, and managers of the business will make decisions focused more on benefiting themselves than on the best interests of the shareholders or even the future survival of the company itself. Sometimes known as agency cost, this type of risk usually has to do with making decisions that generate immediate benefits for certain individuals within the company structure, but lead to either missed opportunities or possible damage to the reputation and future earning prospects of the business. While agency risk may manifest in a number of ways, most will revolve around the use of financial resources and the responsible management of the overhead costs associated with the company operation.
One basic example of how agency risk may be apparent within a company structure has to do with how owners and other decision-makers choose to deal with an unanticipated windfall of additional profits. One approach would involve passing along at least some of those profits to investors in the form of dividend payments while allocating the remainder to a contingency or emergency fund that can be drawn upon to manage debt during an economic slump. A different approach would involve approving pay increases for certain executives or managers, a move that essentially increases the overhead associated with the business operation.
With the former strategy, investors are rewarded for their continuing support, which in turn helps to improve perception of the business. The added element of putting part of the windfall away for future use when needed also has the benefit of increasing the chances that the business can weather an economic downturn, allowing investors to enjoy future dividends and workers to avoid being laid off during that slump. When this type of approach tend to prevail in how the business is managed, the level of agency risk is considered somewhat low.
By contrast, when pay increases are rewarded to certain members of the management team and no funds are directed toward investors or set aside for the company’s future, this is an indication that the degree of agency risk within the company is somewhat higher. Depending on how often decisions are made that tend to favor employees at the expense of investors and general company stability, the risk to investors and ultimately to anyone who depends on the company as a means of earning a living is significantly increased.
Many businesses seek to find some amount of middle ground as a means of keeping agency risk within an acceptable range. This means that while managers and others can look forward to pay raises, approving those increases is balanced with the need to provide equitable dividend payments to investors and set aside resources that help to ensure the company’s ongoing existence. While sometimes difficult to achieve, taking steps that in the long term keep investors happy and create reserves the company can draw upon during a recession or other adverse economic situation limits the degree of risk that everyone connected with the business ultimately assumes.