In this relationship, the board of directors acts as the principal, and the CEO acts as the agent. There may raise some issues or conflicts between the principal and the agent. Negative- If the company executives cut down the price of the shareholders’ stock, then the relationship between them would not be beneficial. A solid and beneficial connection would be built up for the future. Positive- On the contrary, if the company executives financially enhance the shareholders’ stock, the relationship between them would be advantageous. There may be two results based on the type of decision. Hence, the responsibility of making proper decisions lies on the company executives. The effect that may fall on the investment depends upon the decisions made by the company executives. Here, the shareholders invest, and the investment is made to the businesses of company executives.

In this relationship, the shareholders happen to be the principal, and the company executives happen to be the agent. Agency theory is used for explaining and resolving all such agency problems. The agent acts as a representative of the principal in a specific business transaction who is supposed to represent the principal’s best interest without having regard for self-interest.Īt the time, when agents and principals have different interests, it becomes a source of conflict that results in miscommunication and disagreement leading to different problems and discord in the company. Utilizing performance-based compensation can be one of the effective ways for accomplishing a balance between the agent’s and the principal’s interests.Ĭommon principal and agent relationships or agency relationships are associated with shareholders and management, lessees and lessors or financial planners and their clients. The process of resolving the differences in expectations of agents and principals is understood as reducing agency loss. This difference between the two parties (principals and agents) is understood as the principal-agent problem. Principals need agents for executing their specific transactions that lead to a difference in agreement concerning the priorities, interests, and methods.

This is called the “principal-agent problem”. In a business relationship between principals and agents, problems occur due to the disparity appearing in both parties’ opinions, interests, and priorities. What is Agency Theory?ĭefinition: The agency theory is defined as a theory that is used to explain relationships between principals and agents as well as resolve the issues arising because of a conflict of interest between a principal and an agent.Īgency theory is also known as “agency problem” or “agency dilemma”. Therefore, Agency Theory plays an essential role by suggesting the best ways to take care of business relationships to restrain chances of rising conflicts between both parties. Hence, the action of one party can affect the other. In addition to that, it also takes part in solving those issues.īoth the principals and agents are interdependent. This theory is applied to clarify the vexing issues existing between shareholders (business principals) and company executives (agents). Agency theory is a type of practice employed in business-related relationships for explaining relationships between business principals and their agents.

Company principal definition