The Reduction of Agency Costs

Agency theory explains so much of the world. Originating in arguments presented as early as 1932, agency theory describes what happens when owners appoint others to act on their behalf—or, in the theoretical jargon, when principals appoint agents. The core argument is that any organization, at some point, will reach a stage, due to growth or expansion, where the principal cannot do every- thing that needs to be done, so they must appoint someone to do some of the work. This eventuality brings about or facilitates a cost: the person, or agent, appointed by the principal to act on their behalf will require monitoring, which incurs agency costs, also known as monitoring costs. As a leader of a third-­generation European family enterprise shared insightfully, “My sole job is to reduce agency costs.” Broadly, then, the job of a leader is to put in place mechanisms in the organization to ensure that agents’ behavior is aligned with interests of the principals. This alignment is achieved through incen- tives and perquisites.

Importantly, agency costs occur throughout an organization. At the organization’s head, agency costs appear when the owners appoint the board to act on their behalf. The board is monitored through measures such as the strategic planning process and other governance-­related and regulatory mechanisms to ensure those appointed by the owners truly act on their behalf. This is predom­ inant in publicly traded companies but is also the case for private companies, particularly in mature generational businesses with more complex governance structures.

Moreover, one of the responsibilities of the board of directors is to appoint and monitor the CEO. Agency costs, or the potential for agency costs, will occur if the CEO’s actions, decisions, or behaviors are not aligned with those of the board of directors, who are acting as representatives of the owners.

Moving down through the organization, there are also potential agency costs when the CEO appoints their management team. This potential eventuates if those top executives are not aligned amongst themselves.

If you keep the thread going, further down the organization the senior management team is charged with overseeing different areas, be it marketing, finance, IT, logistics, sales, or others. Again, there is potential for agency costs in misalignment of the senior management team with those appointed as division leaders or department heads. These middle managers or supervisors, in turn, will employ line staff, resulting in yet another principal–agent dyad, and the potential for more agency costs.

As such, an organization represents a chain of principals and agents, with the same individuals or entities taking on either role, depending on the dyad relationship in question. Recall, at the top of the organization, the principal was the owner, and the board was the agent; then the board was the principal, and the CEO was their agent; then the CEO was the principal, and their agent was the top management team. The top management team members then repre- sent the principal in their dyadic relationship with their line employees. And so on.

So, as should be evident, agency costs, or the potential for agency costs, are ubiquitous throughout all organizations. It is for this reason that agency is one of the frameworks in the keystone meta-­framework.

Family enterprises are not immune to agency costs, or the potential for agency costs. They too incur costs throughout the organ­ization and the family. In the early days, the owners are also the managers, so there is a reduction of agency-­related costs. But as the company evolves and the family grows, the owners typically must appoint non-­ family employees and managers to assist in operations and non-­family directors to assist in governance. Family and non-­family members will contribute to the potential for agency costs if they are not aligned with the values, beliefs, or vision of the core ownership group.