The figure shows a simplified organizational chart for a large corporation (missing departments - for illustration purposes.)
As you can see from the figure, shareholders effectively hire management. The problem is that management goals are not necessarily aligned with shareholder goals; shareholders want to maximize their share price, whereas managers want to maximize their salaries and keep their jobs.
It may seem that these goals would basically result from the same business strategies, but they don’t always.
Some examples are that managers may want to:
- Expand the business (bigger business = bigger salary)
- Acquire relevant companies at inflated prices (i.e. pay too much!)
- Buy a corporate jet that isn’t actually needed or cost-effective (i.e. less cashflow to shareholders!)
- Not take risks that shareholders would prefer
- For example a shareholder may be well diversified among the drug industry, so it is favorable for the companies to take financial risks to develop the cure for cancer. Failure means that the shareholder will lose their equity in that single business, where as failure to the CEO means loss of job.
What help to align shareholder and management goals?
Luckily for us shareholders, there are three main weapons that we have to keep managers ‘in line.’
First, managers’ main potential income can come from share options. When they are given share options, there new goal becomes to also maximize the share price. They will have incentive to only execute strategies that the market will value and will therefore increase the share price.
Second, we do essentially have the option to hire/fire management if they are underperforming, or not acting optimally. The problem here is that the more shareholders that a firm has, the harder it is to get them all to vote in the same way. Also, many of the shareholders are funds, average people, or organizations (i.e. charities) who are not necessarily active within the company (evaluating management, voting, etc.) So this is a much more powerful weapon with fewer, more active shareholders.
Finally, there is the threat of an acquisition. If a large player notices that the firm is grossly underperforming, he may decide to acquire the firm and turn it around by replacing management.