Agency Theory and Entrepreneurship
Agency Theory: The Battle Between Owners and Managers
Why do investors insist on vesting schedules? Why do Boards of Directors exist? The answer lies in Agency Theory.
Developed in the 1970s and 80s by economists like Michael C. Jensen at Harvard Business School, this theory provides the framework for understanding the often contentious relationship between those who own a company and those who run it.
The Core Players: Principals vs. Agents
Agency theory distinguishes between two parties with distinct roles:
- The Principal (The Owner): The party that delegates responsibility (e.g., the Investor or Shareholder).
- The Agent (The Doer): The party that performs actions on behalf of the principal (e.g., the Founder or CEO).
The theory’s underlying assumption is cynical but realistic: Humans are self-interested. Therefore, the interests of the Principal and the Agent will inevitably diverge. If left unchecked, the Agent will act in their own best interest, not the owner's.
The Root of the Problem: Information Asymmetry
This conflict is exacerbated by Information Asymmetry. The Agent (CEO) is in the office every day; the Principal (Investor) is not.
Because the Agent knows more about the day-to-day reality than the Principal, it is impossible to monitor every action. This "blind spot" creates two specific threats:
1. Adverse Selection (Pre-Contract)
This is the problem of selecting the wrong agent before the deal is signed. Because the founder knows their true ability but the investor does not, the investor risks hiring an agent who claims to be a "star" but is actually ill-suited for the job.
2. Moral Hazard (Post-Contract)
This is the problem of the agent misbehaving after they are hired. Because they aren't being watched 24/7, agents may misappropriate resources. This includes:
- Shirking: Not working as hard as agreed.
- Free Riding: Letting others do the work while taking credit.
- Perks: Excessive consumption of company money (e.g., private jets or fancy dinners).
The Solution: Alignment through Incentives
Since you cannot watch an agent every second, Agency Theorists propose Outcome-Based Incentives.
The goal is to align the Agent's financial interests with the Principal's. This is why Venture Capitalists allocate significant stock options to founders and employees. If the Agent owns a piece of the ship, they are less likely to drill holes in the hull.
Video: Agency Theory Explained
References
Eisenhardt, K. M. (1989). Agency theory: An assessment and review. Academy of Management Review, 14(1), 57-74.
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360.
