Notes on Principal Agent theory and Options

The PA framework well describes scenarios arising in a heterogeneous range of disciplines, such as Economics and Finance, Political Science, Game Theory and Law.

In Corporate Finance, a classical example is the relationship between a Company’s management and its shareholders: the manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize their own wealth.

In Law, there might the case of country not honoring an international agreement or alliance and secretly acting against it.

In Political Science and Economy, we may face the classic problem of a citizen, who by voting a political candidate is by no means guaranteed that the political candidate will honor her/his promises delivered in the political campaign…

At a business perspective, the PA problem may arise between an employer and an employee. Specifically, an employer may want an employee to perform at her/his best, as the employee’s maximum productivity leads to a higher output for the firm. In addition, turnover at a firm may be sensibly costly in terms of the loss of human capital stemming from an employee leaving the firm and the costs associated with search frictions. Thus, firing an employee, even an underperforming one, may not always be feasible. On the other hand, from the perspective of the employee, one may think that to exert maximum effort (e.g., working long hours at maximum productivity) is costly for the employee, or that doing so may not move the employee’s monthly or annual salary much. In addition, the threat and the associated costs of losing one’s job may be smoothed by the existence of unemployment benefits or, given the relatively low level of unemployment in modern societies, the existence of another job paying equally well.

Efficiency wages are among the most studied alternative solutions in economics (e.g., Shapiro & Stiglitz, 1984; Bowles, 2004). According to efficiency wages theory, a firm may have the incentive to pay to an employee a wage that is above the market level wage. Why would that be a good solution?

First, an employee who earns a higher wage may feel motivated to exert a higher level of effort, thus producing more output, to reciprocate the employee’s generosity.

Second, the threat of losing one’s job may incentivize the employees to provide an adequate effort. In fact, underperforming and in so doing being caught may lead to the termination of the job position. Losing a higher than market level salary may be particularly costly for the employee, as it may be difficult to find a second firm paying an above market level wage.

Third, efficiency wages can attract more candidate to applying for a vacancy at firm, thus creating more competition between the candidates, which in turn may raise the quality of the pool of candidates for a given vacancy.

However, what if a firm cannot afford to pay a higher than the market level wage because, for example, the firm is at start-up level or because the cash-flow momentarily prevent it from doing so? Should the firm remain stuck with the possibility of having under-incentivized employees? The answer is a resounding NO! Option theory can help!

How does option theory help? By granting options to the employees, the firm first and foremost aligns the Principal’s incentive with that of the Agent. In fact, the better the firm develops and the more it experiences a healthy growth, the higher its stock price is likely going to be. Obviously, a higher stock price makes the employee richer and happier and, likely, motivated to be as productive as the employee can. It is quite common for Employee Stock Options (ESOP) or, more generally, employee’s incentive plans consisting of options to be subject to the condition of being fully active if the employee remains at the Company. Thus, this may create the incentive for the employee to stay in the firm and therefore lower the attractiveness of an alternative job. In turn, this lowers the probability of costs arising from turnover and help to retain human capital. A stock-option based incentive program helps to attract talented individuals, who may be interested in the potentially infinite upside that options typically provide. A stock-option based incentive program has the benefit of preserving the firm’s cash-flow, albeit at the cost of some dilution for the firm’s shareholders.