Principal-Agent Problem: Act Like an Owner

We spoke earlier about picking a business model that has leverage from scale economies, network effects, 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 was the principal agent problem. 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 a mental model checklist. I know Charlie Munger does, but that's just not how I think. Instead, I tend to focus on the few lessons that I've learned in life over and over that 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. The principal in this case is principal with a P-A-L, not P-L-E, so it's not a principal that you follow. It's a principal who is a person. A principal is an owner. An agent is the person who works for the owner. So you can think of it as an employee, the difference between a founder and an employee. I can summarize this by a famous quote that either was said by Napoleon or by Julius Caesar. It's generally attributed to either one, but he said, "If you want it done, then go. If not, then send." Which is saying, "If you want to do something right, do it yourself." Because other people just don't care enough. Now the principal agent problem pops up everywhere. In microeconomics, the way that they try to characterize it is that 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 guns CEOs running public companies where the ownership of the public company is distributed so widely that there's no principal remaining. So nobody owns more than one percent 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. So agents have a way of hacking systems. This is what makes incentive design so difficult. As Charlie Munger says, "If you can be working on incentives, don't work on anything else." Almost all human behavior can be explained by incentives. The study of signaling and signals 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 the good people aren't purely coin-operated. They're not just looking for money, they're also looking for other things like status or meaning in what they do. The principal agent problem is the one that as a business owner, 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? I think you have to truly have been a founder to fully appreciate how important this founder mentality thing is and what a difficult and gnarly problem the principal agent problem is. What I would say to you is if you are a principal, you essentially want to spend a lot of your time thinking about this problem. What that means is you want to take your top lieutenants and you want to be very generous with them 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 in how they operate. 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 got the advantage in the deal. You negotiate in such a way that you've got the better end of the transaction because eventually the other person will figure it out or they'll be misaligned and the partnership will fall apart. Either way, it's not going to be one of those things that you can invest into with the benefits of compound interest over decades. Finally, if you're in a current role where you're an agent, you're an employee, 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. Because it's training you how to be a principal long term and eventually you will become a principal. It's also going to align you with a principal and a good principal will then promote you or empower you or give you accountability or leverage way out of proportion to what might be your menial role. I'm always very impressed by founders who will promote up very, very young people through the ranks, having them skip multiple levels despite their experience. And invariably it happens because this agent who's way deep down thinks like a principal. So if you can hack your way through the principal agent problem, you've probably solved half of what it takes to run a company. The reason I asked about this one first is because I feel like I personally 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. These are all heuristics that you have designed to avoid having to deal with the single biggest problem in management. Another example of a heuristic you can have that helps you route around the principal agent problem is to deal with the smallest forms possible. For example, when I'm hiring a lawyer or a banker or even accountant to work on my deals, one of the things that I've become very cognizant about is the bigger firms all of the things equal are generally worse. Yes, they have more experience. Yes, they have more people. Yes, they have a bigger brand. But what you'll find is that the principal and the agent are highly separated. And very often the principal will sell you and convince you to work with a firm within all the work will be done by an agent who simply doesn't care as much. And you can end up getting substandard service. So I prefer to work with boutiques and my ideal law firm to work with is a law firm of one my deal banker to work with 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 to. There's nowhere to run. The accountability is extremely high. If you're an agent, the best way to operate is just say 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.