Principal-Agent Problem: Act Like an Owner

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Nivi: We spoke earlier about picking a business model that has leverage from scale economies, network effects and zero marginal cost of replication. There were a few other ideas on the cutting-room floor that I want to go through with you. The first one is the principal-agent problem.

Naval: So mental models are all the rage. Everyone’s trying to become smarter by adopting mental models. I think mental models are interesting, but I don’t think explicitly in terms of mental-model checklists. I know Charlie Munger does, but that’s just not how I think.

A principal is an owner; an agent is an employee

Instead, I tend to focus on the few lessons I’ve learned over and over in life that I think are incredibly important and seem to apply almost universally. One that keeps coming up from microeconomics—because as we’ve established, macroeconomics is not really worth spending time on—is what’s called the principal-agent problem.

In this case it’s a principal, who is a person; rather than a principle that you would follow. A principal is an owner. An agent works for the owner, so you can think of an agent as an employee. The difference between a founder and an employee is the difference between a principal and an agent.

I can summarize the principal-agent problem with a famous quote attributed to Napoleon or Julius Caesar: “If you want it done, Go. If not, Send.”

Which is to say: If you want to do something right, do it yourself; because other people just don’t care enough.

A principal’s incentives are different than an agent’s incentives

Now, the principal-agent problem pops up everywhere. In microeconomics, they try to characterize it this way: The principal’s incentives are different than the agent’s incentives, so the owner of the business wants what is best for the business and will make the most money. The agent generally wants whatever will look good to the principal, or might make them the most friends in the neighborhood or in the business, or might make them personally the most money.

You see this a lot with hired-gun CEOs running public companies, where the ownership of the public company is distributed so widely that there’s no principal remaining. Nobody owns more than 1% of the company. The CEO takes charge, stuffs the board with their buddies and then starts issuing themselves low-priced stock options, or doing a lot of stock buybacks because their compensation is based directly tied to the stock price.

If you can work on incentives, don’t work on anything else

Agents have a way of hacking systems. This is what makes incentive design so difficult. As Charlie Munger says, “Never, ever, think about something else when you should be thinking about the power of incentives.”

Almost all human behavior can be explained by incentives. The study of signaling is seeing what people do despite what they say. People are much more honest with their actions than they are with their words. You have to get the incentives right to get people to behave correctly. It’s a very difficult problem because people aren’t coin-operated. The good ones are not just looking for money—they’re also looking for status and meaning in what they do.

As a business owner you are always going to be dealing with the principal-agent problem. You’re always going to be trying to figure out: How do I make this person think like me? How do I incent them? How do I give them founder mentality?

Only founders can fully appreciate the importance of founder mentality and just how difficult and gnarly the principal-agent problem is.

When you do deals, it’s better to have the same incentives

If you are a principal, you want to spend a lot of your time thinking about this problem. You want to be generous with your top lieutenants—in terms of ownership and incentives—even if they don’t necessarily realize it; because over time they will and you want them to be aligned with you.

When you do business deals, it’s better to have an aligned partnership where you both have the same incentives than a partnership where you have the advantage in the deal. Because eventually the other person will figure it and the partnership will fall apart. Either way, it’s not going to be one of those things that you can invest in and enjoy the benefits of compound interest over decades.

If you’re an employee, your most important job is to think like a principal

Finally, if you’re in a role where you’re an agent—you’re an employee—then your most important job is to think like a principal. The more you can think like a principal, the better off you’re going to be long-term. Train yourself how to think like a principal, and eventually you will become a principal. If you align yourself with a good principal, they will promote you or empower you or give you accountability or leverage that may be way out of proportion to your relatively menial role.

I’m always impressed by founders who promote young people through the ranks and allow them to skip multiple levels despite their lack of experience. Invariably it happens because this agent—who’s way deep down in the organization—thinks like a principal.

If you can hack your way through the principal-agent problem, you’ll probably solve half of what it takes to run a company.

Nivi: The reason I asked about this one first is because I feel like I never see the principal-agent problem in my work. I tend to work in small teams where everybody is highly economically aligned, and the people have been filtered for a commitment to the mission, and everybody else who doesn’t work out moves on to another role elsewhere.

Naval: These are all heuristics that you have designed to avoid having to deal with the single biggest problem in management.

Deal with small firms to avoid the principal-agent problem

Another example of a heuristic that helps you route around the principal-agent problem is to deal with the smallest firms possible. For example, when I hire a lawyer or a banker or even an accountant to work on my deals, I’ve become very cognizant about the size of the firm. Bigger firms—all other things being equal—are generally worse than small ones.

Yes, the big firm has more experience. Yes, they have more people. Yes, they have a bigger brand. But you’ll find the principal and the agent are highly separated. Very often the principal will sell you and convince you to work with the firm, but then all the work will be done by an agent who simply doesn’t care as much. You end up getting substandard service.

I prefer to work with boutiques. My ideal law firm is a law firm of one. My ideal banker is a solo banker. Now, you’re making other sacrifices and trade-offs in terms of that person’s resources—and you are betting big on that person. But you’ve got one throat to choke. There’s no one else to point fingers at; there’s nowhere to run. The accountability is extremely high.

If you are an agent, the best way to operate is to ask, “What would the founder do?” If you think like the owner and you act like the owner, it’s only a matter of time until you become the owner.