The Principal-Agent Problem is everywhere.
A universal mental model for startups, business, politics, and life.
Here’s a breakdown of what it is (and why it matters):
A universal mental model for startups, business, politics, and life.
Here’s a breakdown of what it is (and why it matters):
What is the Principal-Agent Problem?
Imagine a world divided into:
• Principals—owners
• Agents—employees
The Principal is an owner; the Agent works on behalf of the owner.
The Principal-Agent Problem is a term for the conflicting priorities of the Principal and the Agent.
Imagine a world divided into:
• Principals—owners
• Agents—employees
The Principal is an owner; the Agent works on behalf of the owner.
The Principal-Agent Problem is a term for the conflicting priorities of the Principal and the Agent.
This is really about incentives.
As an owner, the Principal's incentives are directly aligned with the outcome.
Due to the lack of ownership, the Agent's incentives may be very different—money, status, esteem, etc.
The Principal has skin in the game, but the Agent does not.
As an owner, the Principal's incentives are directly aligned with the outcome.
Due to the lack of ownership, the Agent's incentives may be very different—money, status, esteem, etc.
The Principal has skin in the game, but the Agent does not.
In a post on this, @naval references a quote by Napoleon or Caesar:
"If you want it done, then go. And if not, then send."
This is a dramatized illustration of the Principal-Agent Problem.
If you want it done, do it yourself; an agent acting on your behalf won't do it well.
"If you want it done, then go. And if not, then send."
This is a dramatized illustration of the Principal-Agent Problem.
If you want it done, do it yourself; an agent acting on your behalf won't do it well.
Once you internalize it, you'll start seeing the Principal-Agent Problem pop up all around you.
It wreaks havoc in startups, business, politics, government policy, and more.
To bring this to life, let's look at a few hypothetical examples of the Principal-Agent Problem:
It wreaks havoc in startups, business, politics, government policy, and more.
To bring this to life, let's look at a few hypothetical examples of the Principal-Agent Problem:
1/ Business
Imagine a public company—Advanced Widgets.
The long-term shareholders of AW are its Principals.
The CEO of AW is their Agent.
The Principals are incentivized by long-term compounded value creation.
The CEO is incentivized by short-term compensation.
Imagine a public company—Advanced Widgets.
The long-term shareholders of AW are its Principals.
The CEO of AW is their Agent.
The Principals are incentivized by long-term compounded value creation.
The CEO is incentivized by short-term compensation.
Well, we have a potential Principal-Agent Problem:
The CEO has big incentive payouts tied to achieving certain short-term targets.
She may be making short-term decisions to achieve these targets that are detrimental to the long-term value creation of the company.
This is bad!
The CEO has big incentive payouts tied to achieving certain short-term targets.
She may be making short-term decisions to achieve these targets that are detrimental to the long-term value creation of the company.
This is bad!
2/ Startups
Imagine a startup—Widgety.
The founder and CEO is its Principal.
The salesperson is her Agent.
The founder is incentivized by her ownership in the company—its long-term growth.
The salesperson is incentivized by commission checks on new contracts signed.
Imagine a startup—Widgety.
The founder and CEO is its Principal.
The salesperson is her Agent.
The founder is incentivized by her ownership in the company—its long-term growth.
The salesperson is incentivized by commission checks on new contracts signed.
Again, we have a potential Principal-Agent Problem:
The salesperson has big commission payouts tied to new contracts.
He may be making short-term decisions to earn these payouts—promising the world to customers and not worrying about future customer churn.
This is bad!
The salesperson has big commission payouts tied to new contracts.
He may be making short-term decisions to earn these payouts—promising the world to customers and not worrying about future customer churn.
This is bad!
3/ Politics
Imagine a country—IncentiveLand.
The people are its Principals.
The president is their elected Agent.
The people are incentivized by the long-term improvement in their quality of life.
The president is incentivized by his continued consolidation of power.
Imagine a country—IncentiveLand.
The people are its Principals.
The president is their elected Agent.
The people are incentivized by the long-term improvement in their quality of life.
The president is incentivized by his continued consolidation of power.
And yet again, we have a potential Principal-Agent Problem:
The president has incentives to act for himself, not the people.
He may be accepting money from big corporations, smearing his enemies, or invading other countries in order to consolidate his power.
This is bad!
The president has incentives to act for himself, not the people.
He may be accepting money from big corporations, smearing his enemies, or invading other countries in order to consolidate his power.
This is bad!
"Show me the incentives and I will show you the outcome." — Charlie Munger
As we can see from these—admittedly dramatized—examples, the Principal-Agent Problem is all about incentive and information alignment.
It's about skin in the game.
So how do we manage it and fight back?
As we can see from these—admittedly dramatized—examples, the Principal-Agent Problem is all about incentive and information alignment.
It's about skin in the game.
So how do we manage it and fight back?
Managing the Principal-Agent Problem starts with awareness.
As an owner, you have to be aware of the power of incentives and the potential conflicts they create.
Constant evaluation of incentives is critical for any Principal—as is a willingness to adjust and align as needed.
As an owner, you have to be aware of the power of incentives and the potential conflicts they create.
Constant evaluation of incentives is critical for any Principal—as is a willingness to adjust and align as needed.
Ultimately, the focus of a Principal has to be on how to create aligned incentives and instill a deep owner mentality in the Agents.
As Charlie Munger says, "Never, ever, think about something else when you should be thinking about the power of incentives."
As Charlie Munger says, "Never, ever, think about something else when you should be thinking about the power of incentives."
As an Agent, your long-term goal might be to become a Principal.
If you want to stand out and optimize your chances of success, you can do so by consistently displaying that you think like an owner.
People who think like owners often achieve accelerated tracks in their careers.
If you want to stand out and optimize your chances of success, you can do so by consistently displaying that you think like an owner.
People who think like owners often achieve accelerated tracks in their careers.
A few key takeaways:
The Principal-Agent Problem is a term for the conflicting priorities of the Principal (owner) and the Agent (employee).
It's about incentives and skin in the game.
Principals should constantly think about incentives; Agents should try to think like owners.
The Principal-Agent Problem is a term for the conflicting priorities of the Principal (owner) and the Agent (employee).
It's about incentives and skin in the game.
Principals should constantly think about incentives; Agents should try to think like owners.
The Principal-Agent Problem is a critical mental model to add to your toolkit.
Follow me @SahilBloom for more threads on mental models, frameworks, and more.
This will be built out into a longer newsletter piece on incentives. Subscribe to get it! sahilbloom.substack.com
Follow me @SahilBloom for more threads on mental models, frameworks, and more.
This will be built out into a longer newsletter piece on incentives. Subscribe to get it! sahilbloom.substack.com
We cover a lot of these topics on my new podcast—Where It Happens. You can find us on Apple, Spotify, or YouTube.
You’ll learn something new every single episode. I know I do! podcasts.apple.com/us/podcast/whe…
You’ll learn something new every single episode. I know I do! podcasts.apple.com/us/podcast/whe…
For more on these topics, I highly recommend the below resources:
nav.al/principal-agent
fs.blog/bias-incentive…
nav.al/principal-agent
fs.blog/bias-incentive…
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