The relationship between management and shareholders is referred to as an agency relationship, in which managers act as agents for the shareholders, using delegated powers to run the affairs of the company in the best interest of the shareholders.

Agency problem is a potential conflict of interest between the agent (manager) and the outside shareholders and the creditors. For example, if managers hold none or very little shares of the company they work for, what is to stop them from working inefficiently, not bothering to look for profitable new investments, or giving themselves high salary or perks?

Agency theory proposes that, although the individual members of the business team act in their own self interest, the well being of each individual depends on the well being of other team members and on the performance of the team in competition with other teams.

One power that shareholders possess is the right to remove the directors from office but shareholders have to take initiative to do this, and in many companies the shareholders lack energy and organization to take such a step. Even so, directors will want the company’s report and accounts, and the proposed final dividend, to meet with the shareholders’ approval at annual general meeting.

Another source of conflict between managers and shareholders is that they have different attitude towards risk. A shareholder can spread his risk by investing his money in a number of companies. A manager’s financial security usually depends on what happens to the one company that employs him. The manager could therefore be more risk averse than the shareholder and not eager to invest in risky projects.

Another situation in which conflicts can arise is when a company is subject to takeover bid. The shareholders of the acquired firm very often receive above normal gains for the share price while managers lose their jobs; if lucky they may be picked by the new shareholders. Therefore, it is not always in the shareholders’ interest that the sought-after companies put up such a defense to drive the bidder away.