The Principal-Agent Problem and Why it Matters

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By starting Nobl I want to prove that consultants and agencies can run a business model that reduces, as much as possible, the principal-agent problem. 

I don’t want to say ‘I make the best decisions for my clients’ I want to create a system that makes it impossible not to make the best decisions for my clients. 

What is the Principal-Agent Problem?

There are many definitions out there but I enjoy the one on Investopedia

“The principal-agent problem is a conflict in priorities between a person or group and the representative authorized to act on their behalf. An agent may act in a way that is contrary to the best interests of the principal. The principal-agent problem is as varied as the possible roles of principal and agent. It can occur in any situation in which the ownership of an asset, or a principal, delegates direct control over that asset to another party, or agent.”

Investopedia

I’ve also heard this problem called simply the ‘agency problem’ or ‘agency bias fallacy’. For this article we will stick with the principal-agent problem. 

To sum it up in my own words it means that everyone acts in their own interest and this can be an issue when you are acting on behalf of someone else.

This problem is every present in society. Employee/employer relationships for example. An employee will inherently do what’s in their best interests as opposed to the best interest of the firm. 

My favourite (or maybe least favourite) example is from the personal finance industry. 

The average financial advisor might recommend people buy certain mutual funds or other financial products and then receive a back-end commission from selling these products. They don’t have a fiduciary responsibility to their clients and only need to sell products that are a “good fit”. 

This is the principal-agent problem at it’s finest. Investors are recommended to buy financial products that aren’t necessarily best suited for them. Rather they are sold a product because it benefits the advisor (agent). 

Why does it matter when working with a consulting agency?

It matters because when a consulting agency is acting on your behalf you need to make sure they are truly acting in the best interests of your firm.

Like in the personal finance example a consulting agency can pursue clients to buy products/services that may not be truly in their best interest. 

And this is obviously a problem, especially when the consulting agency is in charge of client budget (usually advertising investment). 

What can be done to reduce the principal-agent problem?

Start by acknowledging that it exists 

Simply acknowledging that the problem exists is important to reducing it.

However, when you’re buying from a vendor (someone not acting on your behalf) then it’s just generally accepted that the principal-agent problem exists and therefore the onus is on the principal to decide if the buying decision is appropriate or not. 

For example, if you’re buying paid search ads directly from Apple. The relationship is clear, Apple wants to sell their ad product and it’s up to the client to decide if the investment will be worth it. 

In a true principal-agent relationship, when the agent is acting on behalf of the principal, decisions must be made in the best interest of the principal. Even if this means the agent needs to ‘fire’ themselves. 

Open and transparent communication should be standard

Whenever a major decision is being made the agent needs to be upfront about the benefit to them for the client taking that decision. They can achieve this through having a truly transparent operation. 

Compensation of course is important, but there might be additional benefits that the client isn’t aware of, and they should be aware of them. 

Let’s go back to our example with Apple. Imagine now that a consulting agency is buying search ads from Apple on behalf of their client. And Apple is providing the agency with some sort of incentive to spend that money (From the best of my knowledge Apple doesn’t actually do this, but other vendors do). 

There is an obvious problem here. The consulting agency might be recommending the client should spend more money with Apple, when they shouldn’t. Maybe there is a better channel for their investment. Maybe they shouldn’t be investing any more ad dollars at all. 

Although this is becoming less common in the marketplace it’s important to be aware of. 

Aligning Compensations Methods

This brings me to my next point, aligning compensation methods. Again, I would like to take the time to flesh this out in a dedicated post. 

For this post the important thing is to avoid any compensation method that doesn’t align with client business objectives. 

Charging on a percentage of total advertising spend is a perfect example. The only real incentive of the agency is to spend more client budget to increase their fee. Of course there needs to be some performance in order for the relationship to continue but at the end of the day there will be moments when the agent will “spend the money” knowing that it’s not in the best interest of their client and then trying to smooth out the poor performance later. Not good for business. 

Avoiding compensation methods that don’t align with the principal’s business objectives is key. 

Share risk

The next level to mitigate this issue with your agents is around sharing risk with marketing initiatives. I’m planning to write a full blog post addressing exactly what shared risk could look like for me (stay tuned). For now it means that the consulting agency is putting compensation at risk based on a mutual agreed upon outcome. 

Nothing makes me more upset than hearing about advertisers spending large sums of money, seeing little to no results and the agency in charge of the activity holding their hands in the air and saying “well advertising is risky, results aren’t guaranteed!”. 

Sure results aren’t guaranteed but that doesn’t mean we should be spending client budget just for the sake of spending it. 

Unfortunately, the principal-agent problem can’t be fully solved

There are always competing interests between parties. The good news is that it can be mitigated by:

  1. Acknowledging the issue between parties. 
  2. Having open/honest communication between client and agent. True transparency. 
  3. Sharing risk on initiatives to ensure the agent is making decisions that align with the client. 
  4. Aligning compensation methods to ensure they are in the best interest of achieving the required business outcomes. 

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