The Agency Problem and Startups

In any deal, startup founders must think about the other parties’ motivation in all arrangements — even when those people are on your “side.”

Many startup problems are explained by a pretty cool economic theory: the Principal-Agent Problem (AKA the “Agency Problem”). It describes situation where an agent working on behalf of a principal has a conflict around their personal interest. It doesn’t always align with that of the principal.

The most familiar example is home real estate agents. Agents are often in spot where they can work much harder to squeak out a few extra thousand dollars on the sale of a home. Or, they could encourage the seller to take a slightly lower price so the home moves faster. Since the agents are paid on commission, selling a home for a bit less costs them little. But, this outcome could be tens of thousands out of seller’s pockets.

Data supports this. Agents on average sell their own homes for 4.5% more.

While it’s often impossible to avoid this problem in startups, being aware is the first step to minimizing its potentially negative effects.

For example:

  • VC investors often only win if there are outsized returns (5000% or more) at an exit. But, founders might do very well if investors only get a 3x return from a quick exit. So, there’s a disconnect.
  • Sales people with bad compensation plans can make deals that lose the company money.
  • Company lawyers can recommend aggressive litigation strategies that will make them money but also lose money for the company.
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