Corporate governance research has historically focused on agency costs (imposed by professional managers) or principal-principal expropriation (imposed by dominant shareholders). We seek to reverse this theoretical focus on private benefits of control, and its preoccupation with the principal/shareholder and agent/manager dyad, by advancing a conceptual framework of principal costs vis-à-vis the firm.
Principal Costs in the Solo-Owned, Owner-Managed Firm
We trace principal costs to Jensen and Meckling’s seminal 1976 article. Their Figure 1 plots principal costs as a reduction of firm value related to the non-pecuniary consumption of the solo owner – consumption that maximizes the utility of the owner but also reduces the value of the firm. The consumption of a firm’s resources by the solo owner could reduce the value of the firm if an owner pursues pet projects, empire-building, or dynasty-reinforcement, diverts capital for personal use, provides family members with prestigious appointments, perquisites, privileges, and so on.
However, we argue that we should not ignore the benefits of delegation, specialization, and professionalization, i.e., that the consumption of firm resources for the benefit of the principal is not the only source of principal costs in the solo-owned firm. Although solo owners may self-select and start businesses in areas where they are most likely to create value, over the firm’s life cycle, or through growth and diversification, the founder’s competencies may no longer serve the firm well. Consumption of firm resources for personal benefit and competence limitations imposed on the firm by the solo-owner, however, do not need to be mutually exclusive – an owner realizing his or her declining competitiveness may prefer to “milk” the firm rather than extend effort and invest resources in building the solid foundation necessary for the long-term success of the organization.
Principal Costs in the Publicly Traded Firm with Dispersed Ownership
In the publicly traded firm, principal costs could also manifest as extraction of firm resources (e.g., shareholder activists’ demands that the firm borrow money for stock buybacks), or competence limitations imposed advertently or inadvertently on the firm. In this case (absence of control), however, the principal needs a transmission mechanism to influence the firm, and his or her actions could be affected by other shareholders.
Market for Corporate Influence and Principal Costs. Research has viewed shareholder activism as largely part of the beneficial monitoring of corporate managers by shareholders – a corporate governance mechanism that ensures managerial accountability and contributes to the checks and balances on private benefits of control. An implicit assumption of this research is that what is good for the shareholder activist is good for the firm (i.e., the job of managers is to maximize shareholder value, and influential shareholder activists, such as hedge funds, typically seek to increase stock prices).
We relax this assumption and argue that, like the separation of ownership and control, which is expected to lead to agency costs, shareholder influence achieved with a small economic interest in the firm could lead to principal costs. If a shareholder activist with a small ownership stake in a firm manages, for example, to influence the firm’s actions and strategies, the principal would have incentives to make demands for changes that benefit the principal. Two possible objections to this could be that managers would not agree to demands that do not benefit the remaining shareholders (which is at odds with decades-long research on agency costs), or that other shareholders would not allow it (which is at odds with the market for corporate influence research, which notes that behind-the-scenes shareholder activism is widespread).
Private Benefits of Influence. In addition to the overall expectation that the separation of influence and economic interest on the side of the active principal would increase the potential for principal costs (P1a), we also develop two more specific propositions. First, we apply moral hazard to the principal side and argue that the greater the opportunity for private benefits of influence, the higher would be the principal costs imposed on the firm (P1b). In this case, shareholder activism could generate returns for the active principal, while the benefits from those efforts are not shared with passive shareholders.
Temporal Decoupling of Costs-Benefits. Second, we apply the notion of morale hazard – the idea that the principal may prefer to realize benefits in the short term, even if such benefits come at a cost to the firm in the future. The more the benefits to the principal are separated from the future costs to the firm, the higher would be the potential for principal costs (P1c). While an activist shareholder could seek private benefits of influence that are not shared with other shareholders, the activist could also seek to impose costs on the firm (for instance, demands that the firm borrow money to buy back its own stock) via practices that are supported by other shareholders.
Why Wouldn’t Passive Shareholders Constrain Principal Costs? We argue that passive principals may not be able to constrain the principal costs we outlined above for two main reasons: information asymmetries between the active and passive shareholders affected by the pervasive use of behind-the-scenes shareholder activism (P2a), and indifference by passive shareholders to a particular firm (P2b). Diversified shareholders care more about the performance of their investment portfolio than of a specific firm. Furthermore, incentives, investment horizons, and portfolios that include thousands of firms could affect not only the firm-specific indifference of shareholders, but also their inclination and ability to monitor the demands of fellow shareholders.
Bringing the Firm Back into Corporate Governance
The view of the firm as a nexus of contracts has become so dominant that proponents of both shareholder value maximization and stakeholder governance embrace it. According to the former, firms are “simply legal fictions which serve as a nexus for a set of contracting relationships” (Jensen & Meckling, 1976:310); “the corporation is not real” and is “no more than a name for a complex set of contracts among managers, workers, and contributors of capital” (Easterbrook & Fischel, 1985:89), and “a firm itself has no interests” (Inkpen & Sundaram, 2022:9). On the stakeholder governance side, the firm is “an efficient nexus for market contracting among individuals who derive mutual gains from cooperative specialization” (Stoelhorst & Vishwanathan, 2024:13); a “series of multilateral contracts among stakeholders” (Freeman & Evan, 1990:354), or even a multi sided market (Priem et al., 2022).
Yet, how can corporate governance lead to better governed firms if the firm itself is missing – substituted for by shareholder interests, or more recently, stakeholder interests? For instance, can the long-term interests of shareholders be protected, if the firms are treated as “bundles of assets that exist solely for the pocketbook of shareholders;” what are the implications of shareholder empowerment if agency costs and principal costs act as complements, rather than as substitutes; and how would our corporate governance prescriptions change if we placed the success and survival of the firm as a long-term going concern entity front and center?
In our framework, principal costs are imposed on the firm itself. This allows us to avoid a reductionist view of the firm, while considering the heterogenous and dynamic nature of both shareholder and stakeholder interests, as well as the benefits and costs from strategic actions that could occur in different time frames. Such temporal decoupling and heterogenous shareholder interests, in turn, pose challenges for regulators, scholars, and practitioners, while also rendering principal costs more important for corporate governance.
This post comes to us from Maria Goranova, a professor at the University of Wisconsin Milwaukee, and Edward J. Zajac, James F. Bere Professor of Management & Organizations at Northwestern University. It is based on their recent paper, “When the Principal is the Firm’s Problem: Principal Costs and Their Corporate Governance Implications,” available here.