Defining Principal-Agent Relationships for Investment Purposes

As discussed in another article, the modern corporation can be conceptualized in a variety of ways. The set-of-contracts view illustrates that relationships between and among multiple stakeholders is complicated and provides many opportunities for one party to gain at the expense of another party. The Theory of Principal-Agent Relationships recognizes that there can be friction between relationships when one person acts for someone else.

Agency Theory refers to analyses associate with the Principal-Agent Relationship which occurs whenever one person acts in the interests of another. Many situations create a principal-agent relationship between two people. Explicit relationships include those situations where one person acts in the interests of another through contractual agreements. For example, when owners of a corporation hire a manager to run the company using his/her expertise and experience, a formal contract is created where the managers act in the interests of the owners in exchange for compensation such as a salary, stocks, and even perquisites.

Some principal-agent relationships do not operate formally but exist as though there is agency. For example, employees and managers in a corporation do not have a formal agency relationship. This is because the managers do not themselves compensate the employees for working on behalf of the managers. However, at some point in their relationship, the managers must rely on the employees without monitoring them all the time. This relationship can still be defined and governed by theories of agency.

Corporations enjoy four major benefits over other organization forms such as limited liability, permanency, transferability of ownership, and access to capital. These benefits, however, are available because the corporate structure separates ownership from control. Stockholders, the owners of a corporation, do not directly control the interests of a firm. They hire managers to act on their behalf, the classic principal-agent relationship.

However, the relationship is actually a bit more complicated. The owners do not hire the employees of a company themselves. They actually hire top managers, human resources department, and others to hire people to act on behalf of the owners. This complexity can be illustrated further with the set-of-contracts theory of corporate structures. This theory states that organizational relationships are complex with many potentially conflicting legal and moral obligations to stakeholders. The ability to ensure that principal-relationships positively impact each stakeholder rests on the individual relationships that make up the entire system of agency created by the complexity of corporate relationships.

Principal-Agent Relationships range from the simple to the complex. In corporations, the set-of-contracts view of the firm illustrates the complexity of multiple agency relationships across many stakeholders. When an investor values a firm, the evaluation always takes into account the risk associated with the separation of ownership and control. Investors must ask: what assurances are in place to make certain agents in the firm are working for the best interest of the owners?