Principal Agent Relationship

Principal Agent Relationship

Whenever an individual is dependent on the action of another individual, an agency relationship emerges. The individual, who acts, is the agent and the affected party is the principal. For example, a doctor is an agent and the patient is the principal, the consultant is an agent and the client is the principal etc.

The building blocks of agency theory are:  Information: Principal and agents have different information regarding a particular issue. Incentives: The principal and agents as rational individuals might not have sufficient incentives to work towards a common goal. Information and incentive problems are not mutually exclusive. An information problem may arise because the parties may not have suitable incentives to reveal their information and an incentive problem may arise because the parties may not be in a position to costlessly acquire the information they need to evaluate a certain performance. A usual distinction that is made arises from costs that are incurred before a contract is entered and costs that are incurred after the contract has been signed. Before the contract, information asymmetry is the issue as both parties are unsure about the knowledge of the other. If the parties are not able to somehow overcome this concern, there is only a small chance that the parties shall arrive at an agreement. After the contract has been signed, incentives problems arise.

A pictorial representation of the above discussion is presented below:

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Agency Conflicts

Pre investment agency conflicts comprise of adverse selection problems and underinvestment problems. Post investment agency conflicts can be categorized into moral hazard and hold up problem.  

Pre Investment Agency Conflicts

 Adverse selection: There exists an information asymmetry between the entrepreneur and the investor about the quality of the venture. The entrepreneur has a better idea regarding the quality of the venture.  Even if the venture is of questionable quality, the entrepreneur has an incentive of making a favorable projection in front of the investors (since he needs the money)(also known as window dressing). Therefore, the investors are skeptical of the fact that the capital they provide may not be used in the appropriate manner. They counter this problem by raising the hurdle rate (equity against the money that they will invest in the startup) with the thought that only those good quality ventures will accept their terms and conditions. However, this is precisely what leads to the adverse selection process. An entrepreneur who is confident of the quality of his venture does not want to give away a large chunk of his profit to his investors as interests or equity. Therefore, he would ideally stay out and find other sources of financing (the peaches) . Only those entrepreneurs who have absolutely no other source of external financing would come forth to accept the stringent terms and conditions of the investors (i.e. the lemons). In order to meet the high hurdle rate, the entrepreneur would take unwanted risk and hence, the probability of default increases. Therefore, adverse selection leads to the financing of only bad quality venture driving away the good quality ones.