What it means
In business, the owner of a company is the principal, and the employees or managers hired to run operations are the agents. Ideally, both want the company to succeed and grow.
However, human nature and different incentives often create friction. For instance, an owner wants long-term value and high profits, while a hired manager might prefer a quiet life, a larger office, or lower stress levels.
This creates what finance experts call information asymmetry, meaning the manager knows what they are actually doing all day, but the owner only sees the final results. This gap matters because it can quietly drain company profits and misdirect valuable resources.
If left unchecked, managers might take on excessive risks using the owner's capital because they get the upside bonuses without carrying the downside losses. Alternatively, they might play it too safe to protect their jobs, missing out on profitable growth opportunities that the owner would gladly take.
To bridge this gap, businesses use alignment strategies. The most common method is tying a portion of the agent's pay to company performance, such as offering shares, stock options, or profit-related bonuses.
By making the manager a partial owner, their financial health becomes directly linked to the success of the business. Clear reporting, regular audits, and well-defined key performance indicators also help keep everyone focused on the same shared goals.
In practice
Real-world examples.
Example
An e-commerce founder hires a marketing manager and pays them a flat salary. The manager prefers a relaxed routine, so they spend a minimal budget and run basic ads, leaving potential sales on the table while still collecting their full paycheque.
Example
A boutique hotel owner gives the general manager a budget for repairs. The manager delays fixing the air conditioning units to save costs and earn a personal year-end bonus for cutting expenses, ultimately damaging customer reviews and future bookings.
Example
A tech startup's board of directors offers the CEO a large bonus solely for hitting short-term revenue targets. The CEO slashes research budgets and fires vital support staff, boosting current profits before selling their shares and leaving before the long-term damage shows.
Think of it
“Imagine hiring a dog walker and paying them per hour. You want your dog to get vigorous exercise, but since you are not watching, the walker might just sit on a park bench and scroll through their phone while your dog sits beside them, because both options pay the same wage.
Formula
Calculation
Total Agent Cost = Base Salary + Performance Bonus + Monitoring Expenses
Example: If a director's base is GBP 50,000, their performance bonus linked to targets is GBP 10,000, and external audit costs to watch them are GBP 3,000, the total cost of managing the principal-agent dynamic is GBP 63,000.Case study
Seen in the real world.
At Apex Logistics, a regional freight company, the founder stepped back from daily operations and hired a new managing director, Mark, with a fixed salary of GBP 80,000. Within six months, revenues stagnated while administrative costs spiked. Mark preferred a comfortable routine and avoided negotiating tough contracts with major clients, choosing instead to approve expensive company cars for his department heads to keep internal peace. The founder was puzzled by the flat profits despite busy warehouses.
Realising the principal-agent gap, the founder restructured Mark's compensation. They lowered the base salary to GBP 60,000 but added a profit-sharing clause giving Mark 5 percent of any net profit growth above the previous year. Furthermore, the founder introduced quarterly business reviews instead of annual check-ins. Motivated by the direct link between company performance and his own take-home pay, Mark renegotiated supplier deals and cut unnecessary office perks. Within twelve months, net profits rose by GBP 100,000, netting Mark an extra GBP 5,000 while successfully enriching the business.
Watch out
Common mistakes.
- Assuming employees naturally care about the business as much as the owner does without providing proper incentives.
- Using overly complex bonus structures that managers cannot understand or influence, which leads to frustration.
- Failing to monitor performance at all, assuming that high pay alone will automatically guarantee hard work.
Questions
People also ask.
Does this problem only happen with top executives?
No, it happens at all levels. Any time one person relies on another to carry out a task with discretion, such as a sales rep or a cleaner, a miniature version of this problem exists.
Are performance bonuses always the best solution?
Not always. If bonuses are poorly designed, managers might manipulate short-term numbers or take reckless risks to hit targets at the expense of the company's long-term health.
How can small businesses reduce this issue on a tight budget?
Regular communication, transparent goal-sharing, and simple recognition schemes can go a long way in aligning values without requiring expensive corporate compensation packages.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related