One of the most frustrating problems in modern finance is the issue known as the “principal-agent problem.” In fact, most of our modern financial apparatus – the web of banks, equity analysts, media reporters, and Boards of Directors, among others – exist mostly to find an answer to this intractable problem. But what it is?

Let’s imagine that you suffered an injury that prevented you from leaving your home. You’d still need to eat, so let’s say you hire someone to go to the grocery, purchase groceries, and bring them back. You pay them a wage for this service and give them money for groceries.  This employee – this agent – is fulfilling a specific task for you, and you have desires associated with that task. Namely, you’d like them to buy groceries, preferably at the same quality and price point that you would have were you shopping for yourself.

But let’s take a moment to look at the incentives of that person. Once they get to the grocery store, you aren’t there, and they have complete and total control over what they do with your money. They could buy less expensive food than you might desire and cover it up from you, pocketing the excess money. They might take advantage of sales and not inform you – once again, pocketing the difference for themselves. You would not expect them to do this – after all, you’re trusting them with your grocery budget and paying them to be contentious – but you have no idea what they’re doing.

This example is a brief demonstration of the principal/agent problem. You – the principal – are paying an employee – the agent – to provide a service, but the incentives involved encourage that employee to behave in ways you might not desire. How do you solve this? How do you place more control?

In the corporate world, the principals are by-and-large shareholders of companies, the owners of companies that want them run for their own benefit. The agents are the corporate executives, who earn a salary but might be able to benefit themselves in other ways through their power in the company. For example, when it comes time to decide on corporate travel, they might decide that C-level employees only fly first class – a benefit that accrues 100% to the agent, but whose benefit to the principal is less clear.

How to solve this? It is the enduring question of the financial world, one without easy answers.

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Two of the biggest and most successful companies in the world – Apple and Google – are grappling with this question today, both in completely different ways. Their experience has some insight into just how intractable this problem is.

Early conditions at Apple in its entrepreneurial phase meant that its founders were forced to sell off a large percentage of ownership to investors and the broader stock market. As a result, today, those investors wield outsized clout over the company’s operations. They have used this power to dramatically rein in the executives of Apple, dictating policies on a number of issues, but most specifically cash flow allocation.

In 2012, Apple shareholders engaged in a “revolt” against management, demanding that the company pay some of its cash reserves to shareholders in the form of dividends or stock buybacks. In other words, the investors saw that Apple was profitable, and they wanted to have a bit of those profits for themselves in the form of cash payouts. Apple management resisted, stating that they’d prefer to save the cash reserves for future expansion and growth. The power of the shareholders carried the day, and over the next few years, Apple paid out 72% of their operating cash flow.

In this case, shareholders used their power over management to push their own solution to the principal/agent problem, and they were rewarded with a large share of Apple’s profits. But it’s helpful to think about the consequences. There’s reason to believe that Apple may have lost its edge in technology over the last decade, and management is clearly not investing as much in innovation as they were before. Was paying out this cash to investors a mistake?

A counter-example is Google. Google’s founders were able to retain a large percentage of ownership, and they used this power to further entrench themselves, giving their shares larger voting authority than regular shareholders. As a result, Google only distributed 6% of their operating cash flow to shareholders over the same period in which Apple was distributing 72%.

What has that meant for Google? Well, in that period, Google engaged in widespread expansion: self-driving cars, medical research, space technology, and wearables such as Google Glass. Many of these (Google Glass is the most notable) have been unsuccessful – should Google have instead given the amount they would have invested into that project back to their shareholders in the form of dividends or buybacks? Or is occasional failure the price of innovation? Are Apple shareholders taking too much of a short-term view, while Google’s management-centric power structure allowing them to take the long-term view? Or is Google wasting shareholder money on flights of fancy?

We don’t have good answers for these questions, and the principal-agent problem isn’t going away any time soon. As these examples show, there can be good and bad to  both approaches, and we won’t know which path was better (or even if both were good or both were bad) until the future. For now, we must wait and see, while wondering if we will ever find a solution to mismatched incentives and the fundamental question of human association – can I trust you?

To learn more about the principal-agent problem, read Professor Mihir Desai's article about Apple and Google  here, and sign up for Professor Desai's HBX course Leading with Finance today!

Brian Misamore

About the Author

Brian is a member of the Harvard Business School Online Course Delivery Team and was the lead content developer for Leading with Finance and Becoming a Better Manager. He is a veteran of the United States submarine force and has a background in the insurance industry. He holds an MBA from McGill University in Montreal.