The agency problem arises in business when one party, known as the agent, faces the expectation of acting in the best interest of another party, known as the principal. Conflicts of interest can arise if the agent personally gains by not acting in the principal’s best interest. You can overcome the agency problem in your business by requiring full transparency, placing restrictions on the agent’s capabilities, and tying your compensation structure to the well-being of the principal.
Illustrating the Agency Problem
Imagine receiving a windfall of money and hiring a financial advisor to invest it for you. In this relationship, you’re the principal, and the advisor is the agent. The advisor has a fiduciary responsibility to act in your best interest. Unfortunately, incentives may exist for the advisor to undermine your interests and put his needs first.
Suppose the advisor, after learning your financial goals, knows that a growth stock mutual fund is the best vehicle for your money. The advisor also knows they can make a higher commission by placing your funds in an annuity, even though doing so compromises your goals. This is an example of the agency problem. The conflict of interest stems from the financial advisor — the agent — having a clear financial incentive to act in a manner not in the best interest of you, the principal.
Agency problems are most prevalent when there’s a disparity in knowledge between the agent and the principal. It’s too easy and too tempting for the agent to exploit the knowledge gap for personal gain. When agent-principal relationships arise in your business, practising full transparency can help close the knowledge gap and prevent the agency problem from emerging. The agent should educate you, the principal, on everything that’s going on, rather than leaving you in the dark while the agent makes decisions on your behalf.
Restrictions on the Agent’s Capabilities
Giving the agent too much power to act on your behalf opens the door for future challenges and can lead the financial advisor to perhaps make poor choices. Most successful governments practice checks and balances because it tempers the power of any one individual or entity, keeping corruption to a minimum. You can practice the same principles in your business by limiting the power of the agent.
Commission and Bonus Structures
Perhaps the simplest method for eliminating the agency problem is to remove financial incentives that encourage conflicts of interest. Returning to the financial advisor example, the agency problem exists in that scenario because the advisor’s compensation is tied to the specific financial products he offers you.
The products that pay the highest commissions aren’t always the best choices for you, the client. Often the advisor is forced to choose between doing right by his client and maximizing his paycheck. If the advisor receives a set salary or earns commission based on total assets under management rather than specific product sales, the agency problem disappears.
The agency problem happens when conflicts of interest keep one party from acting in the best interest of another party. By taking specific steps and staying organized, you can minimize the chance of this happening in your business. The QuickBooks Self-Employed app helps freelancers, contractors, and sole proprietors track and manage your business on the go. Download the app today.