Principal-Agent Problem
The conflict arising when an agent makes decisions on behalf of a principal but has different incentives.
What is Principal-Agent Problem?
The principal-agent problem describes the conflict of interest that arises when one party (the agent) is hired to act on behalf of another (the principal) but has different incentives, goals, or access to information. The agent may take actions that benefit themselves at the expense of the principal — a situation worsened by information asymmetry, where the principal cannot fully monitor the agent's behavior. In corporate finance, the classic example is the shareholder-manager relationship: shareholders (principals) hire managers (agents) to maximize firm value, but managers may pursue empire-building, excessive compensation, or risk-aversion that serves their own interests. Solutions include equity compensation, performance-based pay, monitoring, and governance mechanisms.
Example
A CEO whose compensation consists entirely of a fixed salary has little financial incentive to work harder than needed to keep the job. Shareholders address this principal-agent problem by granting stock options and restricted stock units (RSUs), aligning the CEO's wealth with share price performance. If the stock doubles, the CEO's equity compensation doubles too — reducing the divergence between agent behavior and principal interests.