Benchmark - Mini Case 2 Suppose you decide (as did Steve Jobs and Mark Zuckerberg) to start a company. Your product is a software platform that integrates a wide range of media devices, including laptop computers, desktop computers, digital video recorders, and cell phones. Your initial market is the student body at your university. Once you have established your company and set up procedures for operating it, you plan to expand to other colleges in the area and eventually to go nationwide. At some point, hopefully sooner rather than later, you plan to go public with an IPO and then to buy a yacht and take off for the South Pacific to indulge in your passion for underwater photography. With these issues in mind, you need to answer for yourself, and potential investors, the following questions. a. What is an agency relationship? When you first begin operations, assuming you are the only employee and only your money is invested in the business, would any agency conflicts exist? Explain your answer. b. If you expanded and hired additional people to help you might that give rise to agency problems? c. Suppose you need additional capital to expand, and you sell some stock to outside investors. If you maintain enough stock to control the company, what type of agency conflict might occur? d. Suppose your company raises funds from outside lenders. What type of agency costs might occur? How might lenders mitigate the agency costs? SUMMARY . An agency relationship arises whenever an individual or group, called a principal hires someone called an agent to perform a service and the principal delegates des sion-making power to the agent. Important agency relationships include those between stockholders and creditors, owner/managers and outside shareholders, and stockholders and managers An agency conflict refers to a conflict between principals and agents. For example. managers, as agents, may pay themselves excessive salaries, obtain unreasonably large stock options, and the like, at the expense of the principals, the stockholders Agency costs are the reductions in a company's value due to actions by agents, includ- ing the costs that principals incur (such as monitoring costs) trying to modify their agents' behaviors. Corporate governance involves the manner in which shareholders' objectives are implemented, and it is reflected in a company's policies and actions See Daniel Eisenberg "No ESOP Fable." Time, May 10, 1999, p. 95. 556 Parts Corporate Valuation and Governance The two primary mechanisms used in corporate governance are (1) the threat of Temoval of a poorly performing CEO and (2) the type of plan used to compensate executives and managers Poorly performing managers can be removed cither by a takeover or by the company's own board of directors. Provisions in the corporate charter affect the difficulty of a successful takeover, and the composition of the board of directors affects the likeli hood of a manager being removed by the board. Managerial entrenchment is most likely to occur when a company has a weak board of directors coupled with strong anti-takeover provisions in its corporate charter. In this situation, the likelihood that badly performing senior managers will be fired is low. Nonpecuniary benefits are noncash perks such as lavish offices, memberships at country clubs, corporate jets, foreign junkets and the like. Some of these expenditures may be cost effective, but others are wasteful and simply reduce profits. Such fat is almost always cut after a hostile takeover. . Targeted share repurchases, also known as greenmail, occur when a company buys back stock from a potential acquirer at a price higher than the market price. In return. the potential acquirer agrees not to attempt to take over the company. Shareholder tights provisions, also known as peisen pills, allow existing sharehold ers to purchase additional shares of stock at a price lower than the market value ifa potential acquirer purchases a controlling stake in the company A restricted voting rights provision automatically deprives a shareholder of voting rights if he or she owns more than a specified amount of stock Interlocking boards of directors occur when the CEO of Company A sits on the board of Company B and B's CEO sits on Als board. A stock option provides for the purchase of a share of stock at a fixed price called the exercise price, no matter what the actual price of the stock is Stock options have an expiration date, after which they cannot be exercised. An Employee Stock Ownership Plan (ESOP) is a plan that facilitates employees ownership of stock in the company for which they work