In any economy complex enough for there to be some people with time and talent but no capital, and others with capital but a shortage of talent or time. When these two archetypes meet, they produce twin offspring: first, the concept of an investment, and second, the conflict between the provider of capital and the person who, day-to-day, exercises control over how that capital is used.

This conflict follows an industry-specific cadence, and a broader cycle. At the industry level, one of the hallmarks of emerging industries is that most successful companies are founder-controlled. That can take two forms:

1. In less capital-intensive industries, like software, early semiconductors, or most service businesses, the company generates the cash it needs for growth from internal operations. So founders don't need much dilution in order to get the money they need for growth.

2. In some industries, there are high capital requirements, but there's also dependence on individual expertise from practitioners, so founders are effectively in control even if they don't own most of the equity. This, for example, describes early railroads (though, in that case, “expertise” sometimes took the form of close relationships with the relevant legislators, lubricated by cash and stock tips.¹

Over time, industries tend to require more capital, and more formal expertise rather than tacit knowledge. So the structure shifts from an owner-operator business where the person who made the first git commit is still running the show, to a separation between professional managers and outside investors. That separation presents a problem: the manager has much less at risk in the company than the investors do, and the investors care more about their returns than the manager does. If a manager owns 1% of the company and outside investors own 99%, then an action that destroys 90 cents on the dollar but transfers the remaining ten cents to the manager is, economically speaking, a win.

There are workarounds, but none of them are perfect. You could ask managers to invest their own money in the business, but then you're restricting your pool of potential managers to the ones who have already made their money, and won't be quite as hungry as the new ones (and you're selecting for a population with a demonstrated ability to earn private return, not necessarily to maximize value for everyone). Which is not a problem—you can give them options instead, or give them an incentive plan tied to profits. But now you've partly aligned one set of incentives (they want the stock to go up) while creating another problem (the manager wants high volatility to maximize the value of that option; at a given level of return, shareholders are better-off if it's low-risk and managers with options are better-off if it's high-risk).

There are plenty of permutations around this that mitigate some of the problems, and in practice management compensation is a wild mix of base salary, incentive-based cash bonuses, various forms of equity that often unlock based on fundamental performance, and—not to be discounted—perks and social status. Making a constant stream of big decisions is tiring, but it's also a nice feeling to be in charge of an important company.²

Agency problems show up at every level of the company, and since they're a conflict of interest they're necessarily bilateral—to define principal-agent problems solely in terms of the agent failing to do what the principal wanted is to assume that investors never opportunistically bend the rules in their own favor. So: companies have a conflict with employees, where those employees aren't motivated to work as hard as shareholders would like, and they use various carrots and sticks to address this. And employees have a symmetrical complaint if the level of work the company is asking for, while nice for the purpose of maximizing shareholder value, isn't aligned with the workload the company told them to expect during the job interview. Employees are making an ongoing intangible investment in the business through the skills and connections they cultivate—there's a force-multiplier in knowing which of your coworkers is likely to have the answer to a question, or knowing how to sequence an N-part negotiation ("We need X to move a meeting around, Y to delay an internal project for two days, and Z to authorize a budget increase": this is always easier if you get two yesses in a row before you ask the person most likely to say "no," and you learn about these propensities on the job.)

The joint-stock corporation made principal-agent problems salient, but it didn't invent them. In fact, it represents another one: granting a company limited liability is implicitly granting it the opportunity to cause net harm to society, and in that sense both investors and managers are agents for everybody else. The law around what companies can do, how they can do it, and how they can be punished for wrongdoing, is itself an extension of the same principal-agent conflict that animates debates over the right base/bonus/equity mix for a new CEO. But, as the wealth of societies with lots of corporations demonstrates, this is a problem that can be artfully managed even if it will never be fully solved.

Read More in The Diff

In The Diff, we’ve looked at the question of agency conflict from many angles:

• Capital-intensity is a state of the industry cycle, not intrinsic to the industry itself ($), so these problems will eventually show up everywhere.

• One part of this cycle is that private equity indirectly restores the owner-operator model.

• Option-based compensation has a surprisingly complex history.

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1  Before stock options became a powerful tool for aligning executive incentives, the economic equivalent was used as a form of bribery: a common way to get a politician on the side of a railroad or other entity from the 19th century through the 20s was to advance a low-interest, non-recourse loan against a purchase of stock. This mimics the payoff structure of a stock option—if you have a $10k loan backed by $10k worth of stock, your wealth consists of whatever appreciation happens after that purchase, and you don't share in the downside since your lender will just seize the collateral. And, at times, members of Congress did act very much in accordance with these incentives.

2  This leads to a tradition that generates more outrage than it probably should: golden parachutes for managers who either get dismissed for performance reasons or leave because the company got acquired. The first-order effect of this is incredibly unfair—someone is set for life after either running the company badly or engineering a merger that might turn their employees' jobs into “synergies”, lead to a worse product, and often even destroy shareholder value over the long term! But the second-order effect is a bit better: it's a way to convert the psychic benefit of having a business card that says "CEO" into a lump sum of cash, which can be the cleanest way to get rid of a bad CEO.