Agency theory is a concept used to explain the important relationships between principals and their relative agent. In the most basic sense, the principal is someone who heavily relies on an agent to execute specific financial decisions and transactions that can result in fluctuating outcomes.
Because the principal relies so heavily on the agent to make the right decision, there may be an assortment of conflicts or disagreements. Agency theory dives into such relationships.
In terms of business, the principal is considered to be a shareholder, while the agent is considered to be a company executive. Although it may not seem like it, shareholders and company executives are tightly connected. Each of their actions greatly affects the position of one another.
Agency theory is also often referred to as the “agency dilemma” or the “agency problem.”
Different Agency Theory Relationships
When it comes to business and the concept of agency theory, there several types of relationships that are closely intertwined and are faced with some sort of disagreement.
Shown below are some of the most in-depth and connected relationships in businesses that involve a principal-agent relationship and qualify for the agency theory.
1. Shareholders and Company Executives
As mentioned, the shareholder is represented by the principal. It is because the shareholder invests in an executive’s business, in which the executive is responsible for making decisions that affect the shareholder’s investment.
If the company executive acts negatively and reduces the worth of the shareholder’s stock, it will spark a disadvantageous relationship.
On the other hand, if the company executive were to act ethically resulting in some sort of financial boost in the shareholder’s stock, a positive connection will form.
2. Investor and Fund Manager
In such a case, the investor is the principal because they are giving a portion of their income to the fund manager to allocate on their behalf.
If the fund manager were to invest in volatile stocks and yield a return less than expected from the investor, a negative relationship begins to form.
Conversely, if the fund manager goes above and beyond and nets a profit outside of the realm of expectation, the investor praises the fund manager and there is a healthy linkage.
3. Board of Directors and CEO
Up in the hierarchy, the board of directors is represented by the principal because their financial position and status are decided by the CEO.
If the CEO were to make a wrong financial decision that put the organization at a deficit, the board of directors is more likely to vote against the CEO in the next election.
Oppositely, if the CEO were to introduce a new business sector that provided unprecedented innovation in the market, they would be praised by the board of directors and would likely stay in power for years to come.
The idea of agency theory is represented by the relationships expressed above.
All of the interactions and disagreements faced by both the principal and agent are what make up the entire exploration of the concept.
Causes of Agency Problems
As mentioned throughout the text, the agency theory explores the distinctive relationship between a principal and their agent. Throughout the relationship, there is a number of actions and decisions that are made by the agent on behalf of the principal.
The same actions and decisions are what generates disagreements and conflict between the two parties. To explain in more depth, listed below are the main causes of agency problems:
When a conflict of interest arises between the principal and the agent
When the agent is making decisions on behalf of the principal that is not in the best interest of each associated party
The agent may act independently from the principal in order to obtain some sort of previously agreed upon incentive or bonus
Confidentiality breach regarding the personal and financial information of the principal