The agency problem arises in business when one party, known as the agent, is expected to act in the best interest of another party, known as the principal. Conflicts of interest can arise if the agent personally gains by not acting in the principal’s best interest. You can overcome the agency problem in your business by requiring full transparency, placing restrictions on the agent’s capabilities, and tying your compensation structure to the well-being of the principal.
Agency Problem Example
Imagine receiving a windfall of money and hiring a financial advisor to invest it for you. In this relationship, you’re the principal, and the advisor is the agent. The advisor has a fiduciary responsibility to act in your best interest. Unfortunately, incentives may exist for the advisor to undermine your interests and put his needs first. Suppose the advisor, after learning your financial goals, knows that a growth stock mutual fund is the best vehicle for your money. The advisor also knows he can make a higher commission by placing your funds in an annuity, even though doing so would compromise your goals. This is an example of the agency problem. The conflict of interest stems from the financial advisor the agent having a clear financial incentive to act in a manner not in the best interest of you, the principal.
Agency problems are most prevalent when there’s a disparity in knowledge between the agent and the principal. It’s too easy and too tempting sometimes for the agent to exploit the knowledge gap for personal gain. When agent-principal relationships arise in your business, practicing full transparency can help close the knowledge gap and prevent the agency problem from emerging. The company should educate the principal on everything that is going on, rather than leaving the principal in the dark while the agent makes decisions on his behalf.
Restrictions on Agent’s Capabilities
Giving the agent too much power to act on the principal’s behalf opens the door for greed and self-interest to corrupt the agent, leading him to choose poorly. The reason why most successful governments practice checks and balances is because it tempers the power of any one individual or entity, keeping corruption to a minimum. You can practice the same principles in your business by limiting the power of the agent.
Commission and Bonus Structures
Perhaps the simplest method for eliminating the agent problem is to remove any financial incentives that encourage conflicts of interest. Returning to the financial advisor example, the agency problem exists in that scenario because the advisor’s compensation is tied to the specific financial products he offers. The products that pay the highest commissions aren’t always the best choices for the client. The advisor is forced to choose between doing right by his client and maximizing his paycheck. If the advisor received a set salary or earned commission based on total assets under management rather than specific product sales, the agency problem would disappear. The agency problem happens when conflicts of interest keep one party from acting in the best interest of another party. By taking specific steps, you can minimize the chance of this happening in your business.