Business Venture Blog
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Anything interesting, really.
Anything interesting, really.
Business Venture Blog
The “agency problem” arises whenever one person (the “Principal”) entrusts another person (the “Agent”) with the power to make decisions that affect the Principal. This could involve entrusting property to the Agent to deal with on behalf of the Principal, or it could involve delegating decision-making power to the Agent that affects the legal rights of the Principal. The core of the agency problem is that the Agent has the authority to act on behalf of the Principal and yet the interests of the Agent may diverge from the interests of the Principal. For example, the Agent may not negotiate as hard as the Principal would on the price of the Principal’s goods unless there is something in it for him. This is a prime example of an “agency cost”.
In Canadian common-law, the essence of an agency relationship is that the Agent can affect the legal rights and obligations of the Principal with the outside world. For example, the Agent can negotiate, enter into contracts, or dispose of the Principal’s property. The list of agency relationships is not closed, but trustee-beneficiary, employee-employer, solicitor-client, and business partners all give rise to certain agency problems. In a corporation, an agency relationship exists between the corporation's shareholders (Principals) and its management (Agents).
The common-law’s solution to the agency problem is the fiduciary duty. The fiduciary duty holds the Agent to a strict standard of conduct. It requires the Agent to exercise reasonable care and diligence (duty of care), and to exercise his authority in the best interests of the Principal, not to obtain a benefit for himself to the detriment of the Principal (duty of loyalty). Courts are reluctant to impose fiduciary duties, particularly in commercial contexts because it is thought to be a “blunt tool” in that it imposes serious legal duties upon one party without much regard for circumstances. To find a fiduciary duty at least three elements must exist (although the presence of all of them or the lack of one of them is not determinative):
(1) The fiduciary has scope for the exercise of some discretion or power.
(2) The fiduciary can unilaterally exercise that power or discretion so as to affect the beneficiary's legal or practical interests.
(3) The beneficiary is peculiarly vulnerable to or at the mercy of the fiduciary holding the discretion or power.
In a corporation, it is the directors and officers who make decisions about the corporation’s business, and it is the shareholders whose property is at stake. As a result, both the common-law and legislation impose fiduciary duties on directors and officers to act in the best interests of the corporation. This public-law solution is good, but as mentioned above, it is “blunt” and not very proactive. There are several other ways that shareholders can protect themselves contractually i.e., structuring the enterprise in a way that aligns the interests of management, with the interests of owners.
In a corporation, agency costs are the costs incurred by the shareholders (Principal) to supervise and control management (Agent). Traditionally, economists point to three ways to effectively control and oversee management:
The market for corporate control, like the fiduciary duty, is criticized as being “blunt” and only really applies when management has seriously failed. It does not proactively prevent mismanagement. The market correction also relies heavily on an efficient market where these kinds of inefficiencies can be addressed immediately. But, transaction costs, market regulations, asymmetric information, and the fact that other firms are not always in a position to acquire make the market for corporate control less efficient.
Similarly, empirical research has shown that board independence is not actually very effective at reducing agency costs or improving firm performance. Boards of directors are rarely truly independent, and even if they are, they are often influenced by management and are less effective at disciplining management and representing the interests of shareholders than one might think. Regardless, in a start-up company, it is unlikely that an independent board of directors is possible.
In very early-stage companies the founder often holds 100% of the company’s capital and manages 100% of the affairs of the business. When the company needs to grow, it needs to attract some form of venture capital. The moment that outside capital is involved, there are going to be agency problems. What you end up with is a company with shareholders who are particularly vulnerable to the control of a single founder or group of founders, and founders who are particularly vulnerable to shareholders who want their money back. Not to mention that both the founders and the shareholders are particularly vulnerable to going out of business. So naturally, agency costs are significant in start-up companies. This partially explains why start-up companies and investors make use of relatively complex investment instruments and shareholder agreements.
Capital structure, shareholder agreements, bylaws, and employment agreements all play a significant role in controlling agency costs in a start-up company. The table below provides a few examples of the legal tools corporations can use to address agency problems. This table is not authoritative and the boundaries between independence, equity, and corporate control are not clear-cut, but hopefully, it gives the reader a sense of the motivation behind certain contractual provisions and rules.
 Dalton et al, “The Fundamnetal Agency Problem and Its Mitigation: Independence, Equity, and the Market for Corporate Control” in James P Walsh & Arthur P Brief, The Academy of Management Annals: Volume 1, New York: Taylor & Francis Group, 2008) 1 [Dalton].
 Trophy Foods Inc v Scott, 1995 NSCA 74 [Trophy Foods].
 Guerin v The Queen, 1984 CanLII 25 (SCC).
 Trophy Foods, supra note 2.
 Lac Minerals Ltd v International Corona Resources Ltd, 1989 CanLII 34 (SCC).
 Bryce C Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice, 3rd ed (Canada: LexisNexis Canada, 2018) [Tingle] at 328.
 Dalton, supra note 1 at 3.
 Dalton, supra note 1 at 27.
 Dalton, supra note 1 at 10.
 Tingle at 329.
Blog posts are by students at the Business Venture Clinic. Student bios appear under each post.