Agency theory and entrepreneurship

What is the agency theory of entrepreneurship?

Agency theory was developed in the 1980s by economist Michael C. Jensen at the Harvard Business School for the purposes of explaining and predicting the behaviors of investors and managers.

Agency theory distinguishes between principals and agents, the former being parties that delegate responsibility for some set of actions to the latter. For instance, entrepreneurs and managers are often the agents of investors, who delegate the responsibility over a business organization.

The theory’s underlying assumption is that both parties are self-interested and that the interests of principals and agents diverge or are in conflict. Therefore, agents may make decisions on behalf of principals that are not in the principals’ interests, which is called an agency problem. For instance, agents may take greater risks than principals would want them too because agents are betting with the principals’ capital.

Agency problems are exacerbated when there is information asymmetry between principal and agents. Agents typically have better information than principals because they are in charge of day to day decisions and are usually closer to the organization than principals, who are typically investors somewhat removed from the business. Information asymmetry makes it difficult for principals to monitor the actions of agents (managers and entrepreneurs), and it is impossible for principals to design perfect contracts to handle all possible scenarios.

Information asymmetry and incomplete contracts generate agency threats called adverse selection and moral hazard. Adverse selection is the problem of selecting agents that are ill-suited, whereas moral hazard is the problem of selecting agents that misappropriate resources. Misappropriation comes in many forms, including free riding, shirking, and the excessive consumption of perks.

Agency theorists propose outcome-bases incentives as solutions to align the interests of agents with those of principals. For instance, venture capitalist will typically allow a significant number of shares in a startup to be allocated to managers and employees as incentives to ensure that they will work toward to the goal of increasing the value of the company shares.

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Eisenhardt, K. M. (1989). Agency theory: An assessment and review. Academy of management review, 14(1), 57-74.

Jensen, M. C., and Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of financial economics, 3(4), 305-360.