Agency Costs and Ownership Structure

We provide measures of absolute and relative equity agency costs for corporations under different ownership and management structures. Our base case is Jensen and Meckling's (1976) zero agency-cost firm, where the manager is the firm’s sole shareholder. Utilizing a sample of 1,708 small corporations from the FRB/NSSBF database, we find evidence supporting several predictions of agency cost theory. Agency costs are found to be: i) significantly higher when an outsider rather than an insider manages the firm; ii ) inversely related to the manager’s ownership share; iii) increasing with the number of non-manager shareholders, and iv) to a lesser extent, lower with greater monitoring by banks. Agency Costs and Ownership Structure The seminal contributions of Jensen and Meckling (1976) on agency costs have called into attention the social and private costs of an agent's actions due to the incomplete alignment of the agent's and owner's interests. Agency theory has also brought the roles of the managerial decision rights and various external and internal monitoring and bonding mechanisms to the forefront of theoretical discussions and empirical research. There have been great strides made in demonstrating empirically the role of agency costs in financial decisions, such as in explaining the choices of capital structure, maturity structure, dividend policy, and executive compensation. However, the actual measurement of the principal variable of interest, agency costs, in both absolute and relative terms, has lagged behind. To measure absolute agency costs, a zero agency-cost base case must be observed to serve as the reference point of comparison for all other cases of ownership and management structures. In the original Jensen and Meckling agency theory, the zero agency-cost base case is, by definition, the firm owned solely by a single owner-manager. When management owns less than 100 percent of the firm’s equity, shareholders incur agency costs resulting from management’s shirking and perquisite consumption. Because of limitations imposed by personal wealth constraints, exchange regulations on the minimum numbers of shareholders, and other considerations, no publicly traded firm is entirely owned by management. Thus, Jensen and Meckling’s zero agency cost base case cannot be found among the usual sample of publicly traded firms for which information is readily available. The absence of information about sole ownermanager firms explains why agency costs are often inferred but not directly measured in the empirical finance literature.