Uncovering the Principal-Agent Problem — and how to de-risk it
You can’t build a business on your own.
There’s simply not enough hours in the day to do everything — from sales, marketing, product and operations. You need to surround yourself with managers that can own these various functions in your business.
Accordingly, founders should keep company with domain experts in these various fields. In effect, delegating these roles to other people to contribute to achieving the mission of the company.
This in itself presents challenges. For starters, managing people is messy — because humans are irrational. We all have our own worldview, values and motivations. This is why leaders require strong EQ. A large part of their job is people management.
The equally challenging aspect of people management is aligning incentives. Effective leaders delegate a lot of responsibility to employees (managers) to own functions of the business. The challenge arises as these managers have their own motivations and incentives which don’t always align with what’s best for the company. Often, there will be conflicting interests between the owners and managers.
Herein lies the Principal-Agent problem.
The principal-agent relationship is the dynamic between the owners of a firm and its employees. The principal is the owner (the founder and other shareholders) and gets financially rewarded by growth in the value of the company. The agent is the employee actually doing the work and gets a cut for their efforts.
The problem exists when the agent optimizes for themselves, as opposed to what’s best for the firm. The heart of the principal-agent problem is managing conflicts of interest.
Agents always have an information advantage
Effective leaders will always delegate divisional responsibility to domain experts. For example, a Chief Revenue Officer (CRO) is employed to manage the sales and marketing function of the business. A CFO is employed to manage the finance function.
The first challenge of the principal-agent problem is that these employees (agents) will have a natural ‘information advantage’ over the principals. As these agents are domain experts, they will see problems or opportunities differently to the principals. It’s also their job to be intimate with these problems and opportunities. The agents will always know more than the principals. They wouldn’t be employed if they didn’t!
This is known as asymmetric information. Asymmetric information is a term used to describe an information advantage that one person has over another. Let’s look at another example — your family doctor. A doctor will typically know more about medical practices and health than you do. Afterall, they’ve spent decades honing their craft at medical school, clinics and hospitals. They know more about medicine and health than you do, hence they have an information advantage over you. The same principle applies to your mechanic. They’ve devoted their time to learning how to fix and maintain cars. They will naturally know more about your car’s problems than you do.
Principals simply cannot be experts at everything. This is why we all employ and pay agents to help with our business and lives.
Information leverage for personal gain
Now, because agents have an informational advantage over principals, they could leverage this advantage for themselves. This can create perverse behaviours.
Take the Chief Revenue Officer for example. Let’s say the CRO has been tasked with improving the sales efficiency of the company. She immediately identifies the need for a new CRM. The CRO has recommended to the principals that the company adopts Salesforce. She recommends Salesforce, not because it’s the best CRM for the company in terms of value for money and features, but rather because she receives a personal kickback in the form of license commissions.
Another example is the CFO’s recommendation for the company to use AMEX cards. Knowing that AMEX has a superior awards points system, he switches all the existing merchant facilities (Visa and Mastercard) to AMEX so that the points accrue to him personally. AMEX merchant fees are more expensive than other credit cards, so the company incurs higher costs, but he doesn’t care because he personally benefits with points funded holidays in the Bahamas.
Because agents have this information advantage and decision-making authority, they may act in their own interest as opposed to what’s best for the company. Hence the principal-agent problem.
The principal-agent exists in almost every case where an economic transaction occurs where an agent possesses more knowledge than a principal. Other common examples include:
- Sales teams maximising short-term sales for commissions, but not lifetime value.
- CEOs maximising accounting profit via ‘financial engineering’ to achieve profit bonuses, but not value for shareholders.
- Real estate agents selling houses below market value for a quick sale to earn commissions faster with less effort.
- Politicians implementing short-term policies to win elections, but not for the greater good of the country.
Are humans inherently selfish?
This discussion unpacks a bigger, more philosophical question — ‘are we all selfish?’ in otherwords, when given the opportunity, do we always optimise for what’s best for ourselves, rather than the firm?
Philosophers have debated this for centuries. In Plato’s “Republic”, Socrates has a discussion with older brother Glaucon in which Claucon insists that people’s good behaviour only exists for self-interest:
“people only do the right thing because they fear being punished if they get caught”
Of course, there is evidence to suggest otherwise. Volunteers of Not For Profits and social enterprises give their time to help others as they’re guided by a moral compass of sorts. Same goes for religious disciples.
This ‘moral compass’ is framed by a set of core values, purpose, and reinforced by a community of like-minded people.
‘People like us do things like this’.
Which is why, from a business context, culture matters. A lot.
How to de-risk the principal-agent problem
1) Culture matters
Creating an organisation with shared values is critical to growing a business. It’s why a leader’s most important role is to constantly remind and preach the core values of the business. To build a culture where agents are aligned with the principals.
When it comes to building a company culture, business leaders can learn a lot from how religious organisations have scaled their reach.
Breaking down the fundamentals of how religion is structured;
- A compelling mission and cause, presented in a powerful narrative
- A set of precepts or core values that help a diverse group of people make decisions
- A brand that disciples will proudly own.
Some food for thought.
2) Flat organisational structure
Fast growing, dynamic companies often have flat management structures. In addition to faster communication and limiting bureaucracy in a firm, the main reason why flat management structures exist is to increase the level of accountability.
In a flat organisation structure, employees are forced to think like managers as they have more ownership and control of their function. Equally, there is no-one else to blame, so the accountability is high. All of this is conducive to enabling managers to think like owners.
The key personnel have a high degree of autonomy and accountability.
If the company grows, we all grow.
3) Financial Incentives
Accountability and culture aside, how do we further motivate people to become the best they can be? How can we incentivise agents to work as hard as principals?
Dan Pink wrote an excellent book on motivation called Drive: The Surprising Truth About What Motivates Us.
When Pink unpacks ‘motivation’, he explains there are 2 specific types: extrinsic and intrinsic.
Extrinsic motivation is driven by external forces such as money or praise. Intrinsic motivation is something that comes from within. It can be as simple as the satisfaction one feels when completing a challenging task.
The challenge is that not all employees have tasks which are intrinsically motivational. Pink describes two distinctly different types of tasks: algorithmic and heuristic
Algorithmic work involves a process which is defined and the end product is expected. We follow a set of instructions which will lead to a known result. By definition, there are no surprises with algorithmic work because there is a known outcome. Algorithmic work includes tasks from manufacturing, selling hamburgers to accountants lodging tax returns. It’s a system of processes that have a repeatable, definable outcome.
Heuristic work is the opposite because there is no algorithm. It entails exploring and testing new methods, processes and ideas to create something new. It’s often challenging as there is no playbook. It requires creativity and critical thinking. Heuristic tasks, might involve launching unmanned rockets into space that return home, writing code that solves a bug in a program to create a new marketing program.
Due to the nature of algorithmic work, it can be boring, so it often requires external motivators in the form of ‘rewards’ to incentivize productivity (think bonuses, Friday drinks etc.) Heuristic work is often intrinsically motivational due to its ‘problem solving’’ and challenging nature. It doesn’t often require external rewards to drive outcomes, as the work itself is rewarding.
When financial incentives fail
Furthermore, when it comes to incentives, Pink asserts that providing extrinsic rewards for heuristic work can be detrimental. Financial incentives such as ‘bonuses’’ for completing tasks have the effect of our narrowing our focus to getting an outcome as efficiently as possible. This is useful for algorithmic tasks, however it can be detrimental to the heuristic tasks — which demands creativity, flexible problem solving.
The other challenge with extrinsic rewards is that it can create perverse behaviour. For example. Enron set lofty revenue goals (as management were financially incentivised to grow revenue) which led ‘financial engineering’, resulting in its collapse. Or, consider the mechanic imposing a sales quota on it’s staff, so workers respond by overcharging customers and completing unnecessary repairs.
So, when do rewards work?
Rewards can work for algorithmic tasks that require little creativity.
As Pink explains:
“For routine tasks, which aren’t very interesting and don’t demand much creative thinking, rewards can provide a small motivational booster shot without the harmful side effects. In some ways, that’s just common sense. As Edward Deci, Richard Ryan, and Richard Koestner explain, ‘Rewards do not undermine people’s intrinsic motivation for dull tasks because there is little or no intrinsic motivation to be undermined.”
Pink suggests you can increase your chances for success when rewarding routine tasks using these three practices:
- Offer a rationale for why the task is necessary.
- Acknowledge that the task is boring.
- Allow people to complete the task their own way (autonomy, not control.
As for incentivising heuristic work, just be conscious that perhaps not everyone is motivated by money. The intrinsic motivator can be the work itself.
Ultimately, by treating people like people, and empowering them to think, act and behave like owners through a set of core values, the principal-agent problem can be reduced as your company grows.
It’s amazing how someone’s IQ can jump a few basis points once you give them challenging work and the authority to act in the best interest of the company.
Who doesn’t want that?