The separation of ownership from control is a common phenomenon in many businesses, especially large corporations. It occurs when the owners of a business, or the principals, delegate the decision-making authority and the management of the business to another party, or the agent. For example, shareholders of a company are the principals who entrust the CEO and the board of directors as their agents to run the company on their behalf.
However, this separation of ownership from control can also create a potential conflict of interest between the principals and the agents, known as the principal-agent problem. The principal-agent problem arises when the agents act in their own interests rather than in the best interests of the principals, resulting in agency costs for the principals.
In this article, we will explain how the separation of ownership from control is related to the principal-agent problem, what are some common examples of this problem, and how it can be solved or mitigated.
What is the Principal-Agent Problem?
The principal-agent problem is a type of moral hazard that occurs when there is a misalignment of incentives and goals between two parties in a contractual relationship. The principal-agent problem was first conceptualized in 1976 by American economists Michael Jensen and William Meckling, who defined agency cost as the cost incurred by the principal due to the divergence of interests between the principal and the agent.
The principal-agent problem generally stems from two main factors: information asymmetry and goal divergence. Information asymmetry means that the agent has more information than the principal about the actions and outcomes of the agent. For example, a manager may have more information about the performance and productivity of a project than the owner. Goal divergence means that the agent has different objectives and preferences than the principal. For example, a CEO may prefer to pursue risky investments that increase their compensation rather than conservative investments that increase shareholder value.
The principal-agent problem can lead to adverse outcomes for the principal, such as:
– Shirking: The agent may exert less effort or avoid responsibilities that are beneficial for the principal but costly for the agent.
– Opportunism: The agent may exploit their information advantage or authority to gain personal benefits at the expense of the principal.
– Moral hazard: The agent may take excessive risks or engage in unethical behaviors that harm the principal but benefit or protect the agent.
– Adverse selection: The agent may conceal or misrepresent their true characteristics or intentions to induce the principal to enter into a contract that favors the agent.
How is the Separation of Ownership from Control Related to the Principal-Agent Problem?
The separation of ownership from control is one of the most common sources of principal-agent problems in businesses. It creates a situation where the owners of a business have limited control and oversight over how their business is run by their agents. Moreover, it creates a divergence of interests between the owners and their agents, as they may have different goals, preferences, risk appetites, time horizons, and incentives.
For example, shareholders of a company want to maximize their returns on investment by increasing profits, dividends, and share prices. However, managers of a company may want to maximize their own compensation, power, reputation, or job security by increasing sales, market share, or growth. These conflicting interests can lead to agency costs for shareholders, such as:
– Managerial entrenchment: Managers may use their authority or influence to protect their positions or resist changes that threaten their interests, even if they are detrimental for shareholders.
– Managerial myopia: Managers may focus on short-term results rather than long-term value creation for shareholders, such as cutting R&D spending or manipulating earnings.
– Managerial empire-building: Managers may pursue expansion or diversification strategies that increase their span of control or prestige but reduce shareholder value or efficiency.
– Managerial opportunism: Managers may use their information advantage or discretion to benefit themselves at shareholders’ expense, such as insider trading, self-dealing, or excessive perks.
How Can Principal-Agent Problems Be Solved or Mitigated?
There are several possible solutions or mitigation strategies for principal-agent problems in businesses. They generally aim to align
the interests and incentives of both parties, reduce information asymmetry and moral hazard, and increase monitoring and accountability. Some common methods include:
– Contract design: The contract between principals and agents should specify clear goals, expectations, responsibilities, rewards, and penalties for both parties. The contract should also be flexible and adaptable to changing circumstances and contingencies.
– Performance evaluation and compensation: The agents’ performance should be measured and evaluated objectively and regularly, based on relevant and verifiable indicators. The agents’ compensation should be linked to their performance and the outcomes for the principals, such as profit-sharing, stock options, or deferred compensation.
– Monitoring and auditing: The principals should monitor and audit the actions and outcomes of the agents, either directly or through intermediaries, such as board of directors, external auditors, or regulators. The principals should also have the right to intervene or replace the agents if they are dissatisfied or distrustful of their performance or behavior.
– Corporate governance: The principals should establish and enforce a set of rules, policies, and procedures that govern the relationship between principals and agents, such as codes of ethics, disclosure requirements, fiduciary duties, or shareholder rights. The principals should also ensure that there is a balance of power and representation among different stakeholders in the business, such as shareholders, managers, employees, customers, suppliers, or creditors.
The separation of ownership from control is a common phenomenon in many businesses that can create a potential conflict of interest between the owners and their agents, known as the principal-agent problem. The principal-agent problem can result in agency costs for the owners, such as reduced profits, efficiency, or value. To solve or mitigate the principal-agent problem, the owners should design contracts, evaluate performance, compensate agents, monitor actions, and enforce governance mechanisms that align the interests and incentives of both parties. By doing so, the owners can ensure that their agents act in their best interests and maximize their returns on investment.