BLAME THE ACADEMICS—AGENCY THEORY
In the early 1970s, Stephen Ross and Barry Mitnick pioneered the concept of agency theory, illuminating the potential for conflict between the interests of corporate principals (shareholders) and agents (managers, including CEOs).
They posited that agents may not always prioritize shareholder interests. To reconcile this divergence and encourage alignment of objectives, proponents of agency theory suggest tying executive remuneration to the company’s performance.
Stock options are an especially effective method to achieve this alignment. Agency theory has several positive aspects, but the negative effect has been instrumental in influencing Boeing.
Here are a few ways the wide-scale implementation of agency theory has impacted corporations:
- Short-term focus: Managers or executives (agents), driven by incentives linked to short-term corporate performance, might prioritize immediate gains over the company’s long-term health. This may mean cutting necessary expenses, like research and development, to boost short-term profits, potentially harming the company’s future growth.
- Increased costs: Implementing mechanisms to align the interests of managers and shareholders (like performance-based compensation) can lead to significant costs.
- Risk aversion or excessive risk: Depending on the structure of incentives, agency theory can either lead to excessive risk-taking or influence managers to become overly risk-averse. For example, if executives’ compensation is closely tied to stock prices, they might undertake risky projects that promise high returns, jeopardizing the company’s stability. Conversely, if their compensation doesn’t adequately reward risk, they might avoid beneficial opportunities, stifling innovation and growth.
- Ethical concerns: The intense focus on financial incentives can also foster ethical issues, encouraging managers to manipulate earnings, engage in creative accounting, or take other actions that boost short-term financial results at the expense of ethical standards, potentially harming the company’s reputation and legal standing.
GREED, GREED, GREED!
At its core, greed is a recurring theme that is stifling innovation. Boeing lost its way as it strayed from its core competency of engineering excellence to one that is more focused on cost-cutting and financial performance. It can be argued that, at its core, the compensation package influenced the executives to make short-term decisions, which resulted in those executives becoming extraordinarily rich. We see this playing out in company after company.
Many of the companies we discussed in the previous article needed to seek outside capital to make their dream of innovation a reality. The venture capitalist (VC) provides the necessary capital to make it happen. Yet, at their core, VC investors are interested in one goal: to find the next unicorn and cash out.
They are constantly looking for ways to fuel growth and encouraging the CEOs to look for ways to grow quickly. It’s insufficient to focus on why they first invested in the company; they want it to keep expanding. In the process of expanding, many companies stray away from their core competency, and another VC enters the mix and now buys the undervalued company. The new investors may extract the value that was always present but never realized due to the lack of focus caused by peripheral expansion away from their core business. This is the danger of the many extremes seen in the Six Cities of Silicon Valley.