What it means
In business, owners and shareholders act as principals, while managers and employees act as agents. The core challenge is that both parties have different priorities and access to different information.
While shareholders want long-term value and profit growth, employees often focus on their immediate salary, job security and work-life balance. Economists call this the principal-agent problem.
This gap in motivation creates what experts call agency costs, which are the expenses incurred to monitor the agent and align their goals with the owner's wishes. For example, business owners might spend money on audits, performance reviews or complex bonus structures to ensure staff behave in the company's best financial interests.
To bridge the gap, modern companies use various incentives. Tying a manager's pay to share price performance or company profit encourages them to think like an owner.
Clear key performance indicators also help principals track whether agents are fulfilling their duties properly. Understanding this dynamic helps non-finance managers see why certain controls exist.
Budgets, approval limits and reporting lines are not just bureaucratic hurdles. They are designed to manage the natural friction that occurs when someone else is spending your money.
The relationship works best when the agent has a stake in the result and the principal can see enough to check the work. Imagine hiring a builder on a cost-plus contract, where you pay the builder's costs and then a percentage on top.
The more the job costs, the more the builder earns, so you need receipts and regular site visits to keep spending honest.
In practice
Real-world examples
Example 1
You hire a property manager to run your rental flat for a 10% fee. You want long-term tenants who pay on time, but the agent just wants to fill the room quickly to secure the commission, leading to poor tenant vetting. Paying the fee only after the tenant's first six months of rent would change the incentive.
Example 2
As a boutique agency owner, you give your sales lead a company credit card. You want them to entertain high-value clients carefully, but they use it for expensive lunches because it is not their personal money being spent. A monthly spending limit and receipt checks reduce the risk.
Example 3
A venture capital fund invests $500,000 into a tech startup. The founders might take excessive business travel perks because they bear only a fraction of the cost, while the investors shoulder most of the financial risk. Investor reporting rights and board seats act as the monitoring tools here.
Think of it
Imagine hiring a dog walker while you are away. You want the dog to have gentle exercise and stay safe, but the walker might rush the route or chat on their phone to finish quickly and move on to their next paid job.
Case study
Seen in the real world
This is a fictional, illustrative scenario. GreenLeaf Landscaping, a mid-sized garden maintenance firm, hired David as operations manager to oversee daily jobs and material purchases. The owner, Sarah, lived two hours away and visited the depot only once a month. Soon, Sarah noticed that net margin had slipped from 20% to 17% despite steady customer demand, a relative fall of 15%.
With annual revenue of $600,000, profit fell from $120,000 to $102,000, a loss of $18,000. David had been approving premium fuel cards and overtime rates for his favourite crew members, making his own job easier by keeping staff happy while ignoring overall business costs. To fix this principal-agent breakdown, Sarah introduced a profit-sharing bonus linked to net margins and required dual sign-off on expenses over $500. Within two quarters, costs aligned with revenue and margins recovered to 19%, worth $114,000 of profit on the same revenue.
The bonus cost far less than the $18,000 the problem had been losing each year. Sarah also began visiting a different job site every fortnight, which showed the crew that spending was being watched and gave David an extra reason to keep costs in line. The combination of a financial stake and light-touch monitoring did more than strict rules alone.
Watch out
Common mistakes
- Assuming employees naturally share the exact same financial priorities as business owners, when each person weighs their own pay, security and workload first.
- Failing to set clear performance metrics, which leaves agents guessing what success looks like and makes later reviews feel arbitrary.
- Over-relying on strict rules without providing positive incentives to encourage good business choices, which can push capable people to look for ways around the rules.
Questions
People also ask
What is the main cause of the principal-agent problem?
It is caused by differing priorities and asymmetric information, meaning the agent knows more about their daily efforts than the principal does.
How can small business owners reduce agency costs?
Owners can use performance-related pay, regular progress reviews and transparent financial reporting to keep staff focused on company goals. Even a simple monthly review of expenses against budget helps.
Does this only apply to large corporations?
No, it happens in any business of any size where one person delegates tasks, authority or spending power to another person.