The agency problem arises when there is a separation between ownership and control within a business. This occurs when the owners of an organisation — known as the principals — appoint managers or executives — the agents — to run the business on their behalf. Because principals and agents may have different goals, motivations, and access to information, conflicts of interest can emerge.
Understanding the Principal–Agent Relationship
The principal–agent relationship is fundamental in modern organisations, especially in large or publicly listed companies. Shareholders (the principals) typically do not manage the business day to day. Instead, they rely on directors and senior executives (the agents) to make decisions, allocate resources, and guide strategy.
This delegation allows shareholders to benefit from professional management expertise, but it also creates the possibility that agents may not always act in the owners’ best interests.
Why the Agency Problem Occurs
The agency problem is rooted in two key issues:
1. Different Objectives
Principals generally want to maximise the long-term value of the business.
Agents, however, may be motivated by:
- Higher salaries or bonuses
- Job security
- Personal prestige or influence
- Short-term performance targets
- Perks such as company cars, travel, or benefits
These differing priorities can cause managers to make decisions that benefit themselves rather than the shareholders.
2. Information Asymmetry
Agents usually have far more information about the company’s operations than the principals do.
This imbalance can make it difficult for owners to monitor managerial actions effectively.
Examples of agency issues include:
- Managers inflating short-term profits to earn bonuses
- Taking excessive risks in pursuit of growth
- Avoiding difficult decisions to protect their own positions
- Misusing company resources
- Failing to act decisively because it might harm personal reputation
In extreme cases, weak oversight can lead to serious mismanagement or even fraud.
Tools to Reduce the Agency Problem
Businesses use a range of governance mechanisms to align the interests of agents and principals:
1. Performance-Based Compensation
Linking executive rewards to measurable performance indicators — such as profit, share price, or long-term value creation — encourages managers to act in the company’s best interests.
2. Strong Corporate Governance
Independent non-executive directors, audit committees, and clear accountability structures help monitor managerial decisions and reduce conflicts of interest.
3. Shareholder Rights and Oversight
Shareholder voting, annual general meetings (AGMs), and the ability to appoint or remove directors ensure that principals retain ultimate control.
4. Transparency and Reporting
Regular financial reporting, disclosure requirements, and external audits reduce information asymmetry and make it harder for agents to conceal poor or self-serving behaviour.
5. Executive Share Ownership
Providing shares or share options encourages managers to think and act like owners, aligning long-term incentives.
Why the Agency Problem Matters
The agency problem is central to corporate governance, business ethics, and financial management. Poorly managed agency relationships can lead to inefficiency, declining performance, and loss of shareholder value. Conversely, when incentives and oversight are well designed, principals and agents work together effectively to achieve organisational success.
