Agency Theory

Agency theory explores the establishment of agency relationships to reduce the occurrence of disputes and other issues between agents and principals.


What Is the Agency Theory?

In a business environment, agency theory is a way to describe interactions between principals and their agents. This hypothesis is used to shed light on the conflicts between shareholders (business owners) and firm leaders (agents). Additionally, it contributes to resolving such problems.

Principals and agents are dependent on one another. Therefore, one party’s behavior can have an impact on another. Agency theory advises the best methods to manage corporate interactions to reduce the likelihood of escalating disputes between the parties.

How Does Agency Theory Work in a Business Environment?

Here are a few instances of how agency theory functions in business interactions.

Directors and Stockholders

Shareholders (owners of a company) cannot operate the company as there is a need for efficient and experienced staff to boost productivity. Therefore, they assign this duty to a chosen manager(s). In this case, the shareholders serve as principals and the management team as agents.

Since this allows a division between ownership and control, conflicts between management and shareholders do occur. It is possible that the management is prioritizing its own interests over that of the shareholders.

The agency theory enters the picture here. It states that all of the agents’ acts must be directed at advancing the shareholders’ self-interest.

Fund Managers and Investors

A fund’s principals are its investors, while its managers serve as its agents. Fund managers could put their own interests—like earning big commissions—ahead of the interests of investors.

When agency theory is used, it is necessary for fund managers to behave in the investors’ best interests while receiving a fair remuneration.

Employers and Workers

The connection between an employer and an employee is quite similar to everything mentioned above. Employees are expected to behave in the employer’s best interests, while employers are expected to make sure they are fairly paid.

How to Solve Agency Problem? 

The agency theory in an organizational setting pertains to how the company can encourage or inspire its agents (which may include its workers) to act in the organization’s best interest rather than their own self-interest.

Profit sharing and performance-related pay techniques may assist internal agents—that is, agents who work for the company—overcome the agency problem. With this straightforward solution, agents are encouraged to put in extra effort to further the objectives of the business; for instance, if the team achieves its performance indicators, employees receive cash or holiday bonuses. For top executives, stock options and other long-term incentives offer a way to link their interests with the company’s financial success, thereby putting them on the same side of the profit-motivated spectrum as the shareholders.

Use clear language and instructions in a contract for external agents, like consultants and contractors, to get around the agency problem. You should be really clear about the extent and limitations of the agent’s power, and you may align your interests by tying the agent’s degree of remuneration to the achievement of particular tasks or outcomes.