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. These 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 members behave in the company's best financial interests. To bridge this 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.
In practice
Real-world examples.
Example
You hire a property manager to run your rental flat for a 10 percent fee. You want long-term tenants who pay on time, but the agent just wants to fill the room quickly to secure their commission, leading to poor tenant vetting.
Example
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.
Example
A venture capital fund invests 500,000 pounds 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.
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.
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 profit margins dropping by 15 percent despite steady customer demand. 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 pounds. Within two quarters, costs aligned with revenue, and margins recovered.
Watch out
Common mistakes.
- Assuming employees naturally share the exact same financial priorities as business owners.
- Failing to set clear performance metrics, which leaves agents guessing what success looks like.
- Over-relying on strict rules without providing positive incentives to encourage good business choices.
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.
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.
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