It's hard to get other people to care about what you do. And it's almost impossible if they don't have the same "skin in the game" - if they aren't rewarded or punished directly based on the outcome of their decisions.

It turns out this is a very old problem. It's called the principal-agent problem. And if you're an owner or an employee, you have to understand it. 

Here's Naval Ravikant on how critical this understanding is, from The Almanack of Naval Ravikant: 

To me, the principal-agent problem is the single most fundamental problem in microeconomics. If you do not understand the principal-agent problem, you will not know how to navigate your way through the world. It is important if you want to build a successful company or be successful in your dealings. 

If you want to move up quickly in your company or start a successful business of your own, read on.

What Is The Principal-Agent Problem?

The principal-agent problem is a name for the inherently competing priorities between an owner (the principal) and an employee (the agent). The agent rarely acts in the best interest of the principal. Instead, the agent acts in their own best interest.

Naval gives us a clear definition of the principal-agent problem: 

Julius Caesar famously said, "If you want it done, then go. And if not, then send." What he meant was, if you want it done right, then you have to go yourself and do it. When you are the principal, then you are the owner—you care, and you will do a great job. When you are the agent and you are doing it on somebody else's behalf, you can do a bad job. You just don't care. You optimize for yourself rather than for the principal's assets.

Every time a principal hires an agent, they give away a certain degree of control over the asset they own. In giving over control, the principal will either benefit from an agent who does a great job or suffer from a poor one. While the agent controls the project or asset, it's the owner who owns the outcome. The owner has skin in the game.

This is why if you're a principal - a founder, owner, manager, or boss that oversees the work done by other employees, you need to know how to delegate effectively. You need to understand the power of incentives. And how you can use incentives to align your goals with those of the agent who controls your assets.

The heart of the problem is that the principal - the person who owns that asset - will always care more about it than the person he or she hires to manage the asset. It's the law. And you need to learn how to correct for it.

Examples of The Principal-Agent Problem 

Small Business Owner And Employee

Say a principal owns a small paint store. What do they care about? Revenue. They care about excellent customer service to keep customers happy and coming back for more paint. They also care about keeping their expenses low and widening their profit margins. 

The principal has an agent (employee) that works on the paint shop floor to stock shelves and answer customer questions. What does this agent care about? Making more money. So, they go to the owner and ask for a raise on their hourly rate.

The principal wants to keep expenses low (and profit margins wide), while the employee wants more money. This is the principal-agent problem.

Home Buyer And Realtor

A young couple wants to find the perfect house as first-time home buyers. So, they hire a realtor to find them their dream house. 

What do the principals (buyers) care about? Finding the perfect home within their budget.

What does the agent (realtor) care about? The commission they get from selling the most expensive home that the couple will say yes to as quickly as possible. 

Of course, the realtor does care about the happiness of the couple, but they probably care more about the commission check. This is the principal-agent problem. 

Shareholders and CEO

The principals of a publicly-traded company are the shareholders. These shareholders hire a CEO to run the business.

What do the principals care about? Boosting the stock price or getting a dividend check, so they make more money.

What does the agent care about? Well, the agent is the one who must run the business. And it's much easier to run a business when your employees, managers, and executive team are happy and working hard. 

So, the agent may decide that instead of a dividend payment to the shareholders, they will funnel profits back into the business with bonus checks and pay raises to the managers and executives. This is the principal-agent problem. 

Correcting For the Principal-Agent Problem With Incentives

The best way to solve the principal-agent problem is to craft the right incentives for the agents. And these incentives should align with the incentives of the principal. 

Incentives are rewards and punishments that impact human behavior. In business, incentives could be money, status, company perks, equity in the business, the ability to work from home, a fat expense account, etc. 

Charlie Munger has a great quote that says: "Show me the incentive and I will show you the outcome." Incentives are that important.

Here's Naval on the power of incentives from an article on his site:

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.

The principal must find a way to incentivize the agent to do what's in the business's best interest.

Take the paint store example above. Instead of handing the agent an hourly pay raise, the owner could offer an additional commission bonus based on the number of paint cans the employee sells. Or, the owner could offer a commission based on the number of repeat customers the store gets. This would incentivize the employee to provide great customer service because he knows he'll make more money if the customers return to buy more paint. 

In a publicly-traded company, the shareholders could incentivize their CEO by tying a portion of their compensation to the price of the stock (this happens all the time). This would change how the CEO makes decisions and runs the business to align with the principals' wants.

Incentive design is one of the single most crucial jobs of an owner. Successful businesses get it right.

If You're An Employee, Act Like An Owner

If you're an employee and want to get ahead, you need to learn to think like a principal. Instead of asking, "what's best for me?" ask, "what's best for the business?" Counterintuitively, this is the fastest way to get ahead. 

Principals who see their agents acting like principals will quickly give them more responsibility, resources, and money.

Naval writes:

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.

This is more likely to happen in a small company than a larger one. At a small company, there's more freedom for principals to build incentives that help the agent think like an owner and more freedom to tie compensation directly to the value the agent creates.

So, think like a principal. Before long, you'll be one. 

Special thanks to Emma Cranston for her help in creating this article.

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ARTICLE SOURCES

Jorgenson, Eric. The Almanack of Naval Ravikant: A Guide to Wealth and Happiness. Magrathea Publishing. Kindle Edition.

You can read Naval’s article on the principal-agent problem here: https://nav.al/principal-agent