Agency Theory

What is agency theory?

Agency theory, also known as the agency problem or the agency dilemma, explains and resolves issues in business relationships between principals and agents. Principals may refer to shareholders, whereas agents may refer to company executives. In these instances, the shareholders rely on the company executives to make decisions that will positively affect the shareholders’ investments. 

Agents often use investor relationship management software to manage relationships with their investors. 

Types of agency theory relationships

An agency can refer to different types of relationships between parties. Below are some of the most common:

• Shareholders and company executives: Shareholders are principals, and company executives are agents. In this type of relationship, company executives make decisions that impact shareholders’ investments and financial position. 
• Investor and fund manager: In this type of relationship, the investor is the principal, and the fund manager is the agent. The investor grants decision-making authority to the fund manager to allocate funds accordingly. 

Components of agency theory

Agency refers to a relationship in which an agent represents the principal in day-to-day activities. Typically, principals hire agents to perform services on their behalf and delegate decisions to the agents. 

Decisions made by agents affect principals financially. As such, it’s not uncommon for differences in opinions and priorities to arise. When differences occur, these misalignments are known as the principal-agent problem.

Causes of the principal-agent problem in agency theory

The principal-agent problem happens when conflicts and misalignments arise between parties. These conflicts and misalignments emerge for many reasons, including:

• Differing interests between the principal and agent
• Poor decision-making by an agent that doesn’t lead to a profit for the principal 
• Lack of communication 
• Broken confidentiality agreements 
• Lack of trust between the principal and agent

Agency theory vs. stakeholder theory

Both agency theory and stakeholder theory explain business relationships. Agency theory is concerned with issues between principals and agents. 

In comparison, stakeholder theory suggests anyone affected by a product or service should be considered a stakeholder in the business. According to stakeholder theory, business decisions should be made based upon a collective decision by all stakeholders.