Agency Theory & Small Businesses Essay

2540 Words Aug 9th, 2014 11 Pages
Word count: 2251
Background:
Agency theory (Jensen & Meckling 1976) has provided useful insight into the financial dealings between an enterprise (principal) and its stakeholders (agents). It is unlikely that the economic interests of these parties will be exactly the same because it is human nature to maximise one’s own benefit even at the expense of others. (Peacock, p278)
Question:
Explain how agency theory may be applied in explaining the relationship between small business and a financial institution. Include, as part of the discussion, an explanation of the costs and benefits of the relationship that may be attributable to the existence of an agency relationship. (2500 words).

Around 96% of businesses in Australia are small
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In order to avoid conflict, the principal enforces legally binding contracts to guide the agent and ensure that the agent’s actions are in line with the principal’s requirements.

Bank loans to small businesses have been steadily decreasing over the last decade (Small Business Trends). This is due to the fact that the banks make more profit lending to large corporations, as there is a general trend that indicates that as loan size increases company revenue tends to increase faster than costs (Small Business Trends). Financial institutions also see lending money to small businesses as a risky undertaking. Not only is there less reliability in the information flow, as small business are under no obligation to provide financial statements to outside entities, but small businesses tend to have high failure rates due to mismanagement, or operating in an uncertain environment that they have little control over, or a lack of resources (Peacock 2004).

As the economic interests of the principal and the agent may not be exactly in line with one another, the principal may be inclined to regard investment in a small business as more risky, and may charge higher interest rates (Thompson, 2012). Banks are primarily concerned with the proposition of the business enterprise; a clear reason for requiring funds must be given by the agent. As the lending to a small business is based on future revenue and a return on the investment, a clear and