Principal agent theory, which emerged in the 1970s from a number of economists and theorists, describes the pitfalls that often arise when one person or group, the “agent,” is representing another person or group, known as the “principal.”
We hire an agent—such as a lawyer, real estate agent, business adviser, diplomat, or entertainment agent—when we lack the knowledge, experience, or access needed to carry out a particular negotiation effectively. Though agents can be indispensable in certain contexts, their role can be fraught with peril for the principal, as principal agent theory suggests.
Problems can arise due to the fact that an agent’s interests are rarely identical to those of her principal, typically because of the agent’s fee structure, write Robert H. Mnookin, Scott R. Peppet, and Andrew S. Tulumello in their book Beyond Winning: Negotiating to Create Value in Deals and Disputes. In a real estate deal, for example, a buyer’s agent typically has little interest in getting his client the lowest price possible on a home. The higher the sale price, the higher his commission, a percentage of the sale price, will be.
Even a seller’s agent may not be as aggressive as she could be on price, perhaps because she wants to maintain a collegial relationship with the buyer’s agent or wants to wrap up the deal quickly. In fact, a study of 10,000 home sales by University of Chicago professors Steven D. Levitt and Chad Syverson found that real estate agents kept their own homes on the market about 10 days longer than their clients did, on average, and sold their own homes for 3.7% more.
Like all of us, agents typically are unaware when conflicts of interest compromise their decisions. But such perverse incentives are typical of principal-agent relationships.
A suspicious negotiation
Consider the scrutiny that followed the announcement in February that author Harper Lee would be releasing a prequel to her classic novel To Kill a Mockingbird. Lee had written the novel, Go Set a Watchman, in the 1950s. She deemed it unworthy of publication at the time. Many observers raised doubts that Lee, who is in her late 80s and suffered a stroke in 2007, had decided freely and of her own accord to publish the novel many decades later. Had her agent, lawyer, and publisher took advantage of her due to their own financial incentives in the deal? An investigation by the state of Alabama turned no evidence of elder abuse, but the details of the book negotiations remain foggy.
Principal agent theory finds flaws with virtually all types of fee structures that are commonly used to compensate agents. Agents who bill by the hour, for example, gain incentives to drag out their work.
Principals often have difficulty monitoring their agents’ work to ensure they are performing efficiently.
4 guidelines for managing agents
How can you minimize the perverse incentives identified by principal agent theory and ensure that your agent will get you the best deal possible? The following four guidelines should help:
– Investigate the agent’s negotiating style.
Many agents brag that they are “sharks” who will bargain ruthlessly on your behalf. Beware agents who bring this type of win-lose mentality to their negotiations. Instead, look for an agent who recognizes the value of collaborating to enlarge the pie of resources with the other party before fighting hard to get you the biggest slice.
– Negotiate your role.
Discuss with the agent what your role will be in the negotiation. Will you be at the table with the agent serving as a behind-the-scenes adviser? Will you be absent and reliant on the agent to fill you in on what happens? Negotiate an arrangement that makes sense to you both based on your individual strengths.
– Don’t give away your bottom line.
Negotiators often err in telling their agents how low or how high they are willing to go to make a deal. That’s typically a mistake, as it could anchor the agent toward an unambitious goal. Giving an agent the ability to agree to a particular figure also hands over too much negotiating authority. Instead, you might give your agent the freedom to brainstorm options at the table but not the ability to make binding commitments without your approval.
– Negotiate the terms of your agent’s contract.
Agents typically present their contract terms as standard, but that doesn’t mean they’re non-negotiable. Share your concerns about your potentially misaligned incentives and ask your would-be agent to help you tailor her fee arrangement to the situation, advise the authors of Beyond Winning. A fixed fee may be best if you want the work done quickly and at a low cost, while an hourly rate may be more appropriate if you are looking for her to leave no stone unturned.
Principal agent theory highlights the risks of negotiating through an agent. By managing these risks, you can increase the odds that your agent will bring you a better deal than you could have negotiated yourself.
What do you think about principal agent theory? Share your thoughts in the comments.