When owners of a business and the management for the business are different, differing objectives and incentives can lead to formation of moral hazard problems, also referred to as principal agent problem in a benign manner (Cole, He, McCullough, & Sommer, 2011).
Management can have its own agendas and objectives and would formulate business plans and strategy in order to achieve such objectives. On the other hand, the owners might have different objectives, but do not participate in day to day decision making of the firm’s business.
Thus, in order to maximize their incentives, management may resort to excessive risk taking behaviour, something which may yield positive results in the short term, but may be harmful for the business in the longer term. This situation of moral hazard is thus created as the objectives and incentives for the owners and the management are different (Cole, He, McCullough, & Sommer, 2011).
In order to minimize such a problem, there can be solutions such as stock options as performance bonus for management, entering into long term service contracts with senior management and also efficiency wages (Abdalla, 2008).
Stock option based performance bonuses can mean that the management would work in a way such that the whole firm benefits, thus adding to the shareholder value as well. But there have been empirical shortcomings in this approach, whereby agency problem has increased rather than reducing.
The most popular mean of reducing this problem is to offer management long term service contracts. As the management would be aware that they would have to spend a long time at the firm, they would make decisions taking into account the long term objectives of the company.
The other solution is to offer efficiency wages to the employees. This would prevent them from slacking off from work.
References
Cole, C. R., He, E., McCullough, K. A., & Sommer, D. W. (2011). Separation of Ownership and Management: Implications for Risk-Taking Behavior. Risk Management and Insurance Review, 14(1):49-71.
Abdalla, K. (2008). Principal-Agent Problem. Jargon Alert. Retrieved from https://www.richmondfed.org/~/media/richmondfedorg/publications/research/region_focus/2008/fall/pdf/jargon_alert.pdf.
