Principal Agent Problem

November 2, 2023

I first heard about the Principal Agent problem from a Naval podcast - and as soon as I heard it, I deeply resonated with it. In short, it's the incentive dichotomy that exists between the principal of a company and the agents that work for that company. The principal (employer) wants what's best for the long term future of company whereas the agent (employee) wants what's best for their career. This split in incentives is understable, a principal owns equity in the company and the long term future of the company being in good standing means the principal is in good standing. However, an agent's incentives often differ, and it depends on the flavour an agent comes in -

  1. An agent that wants to maximise their future returns, which means doing good work. This requires a certain level of sacrifice, similar to sacrifices that the principal will also make for the future of the company (top performing agents fall under this category),
  2. An agent can be just keen on maximising current returns while also having time for themselves outside of their role (most agents will fall under this category),
  3. Often times, however, an agent doesn't even have that desire, and is performing a job in order to get by. No need to maximise current or future returns (hard to define what will motivate them).

The problem is - what practices does a principal need to employ to align the incentives of the agents with the principals?

Alignment is hard in scenario 2 and near impossible in scenario 3. I've noticed big tech companies will seriously struggle with these incentives. That's reasonable because the incentives naturally mis-align as the distance between the principal and agent increases. Amazon tries to solve this model by letting each team manager work as the principal, and each team supports a distinct finite product or bordered-part of the product. However, with time, there's small occurences of Peter's principle, where you'll have middle managers that will invariably take autonomy away from the original principal.

I'm far from a management expert, but middle management is the bain of the principal agent problem. How does one give autonomy to product owners if there are multiple layers of them?

What's the solution?

The goal is to eliminate the distance between the principal and the agent.

A lot of the times, companies will throw money at the problem (performance based compensation, benefits, bonuses)- but unless the root cause is determined, this will not work.

The best way to do that is a small, lean, ambitious team of great engineers who are both excited by the technical challenges as well as providing real value to customers.