Strategic Business Leader · Agency

Agency Theory and the Agency Relationship in SBL

Updated 11 October 2026 · Fact-checked

Agency theory describes the relationship in which owners (principals) hire managers (agents) to run a business for them. Ownership and control are separated, so the agent may act in their own interest rather than the principal's. To answer SBL questions, identify the parties, their objectives and the gap between them, then apply it to the case.

Understand Agency Theory and the Agency Relationship

An agency relationship exists when one party, the principal, appoints another party, the agent, to act on their behalf and gives the agent some decision-making authority. In corporate governance the principals are the shareholders. The agents are the directors, who run the company day to day.

This arises from the separation of ownership and control. In a small business the owner usually manages it. In a large company, thousands of shareholders own it but cannot all run it. They appoint a board. The board in turn appoints senior managers. Each step in the chain can be an agency relationship.

The key point is that principal and agent may want different things. Shareholders typically want long-term growth in shareholder value. Directors may want higher pay, job security, status, a larger empire or less risk to their own position. The agent also usually knows more about the business than the principal. This is information asymmetry, and it makes it hard for shareholders to judge whether directors are acting in their interest.

The roles are clear. The principal provides capital, sets objectives, appoints and removes directors and votes at general meetings. The agent makes decisions, manages resources, acts in good faith and reports to the principal. Reporting through the annual report and accounts is how directors are held accountable. This is often called stewardship accountability.

In the exam, agency theory is a lens, not a list to recite. You must link it to the scenario: who is the principal, who is the agent, what has the agent done, and what is the effect. Remember that agency theory focuses on shareholders. It is often criticised for ignoring other stakeholders, which is covered in related topics.

Key rules to remember

Agency relationship: Principal (shareholders) → delegates authority → Agent (directors); The agent acts on behalf of the principal. In companies, ownership and control sit with different people.
Source of the agency problem: Separation of ownership and control + differing objectives + information asymmetry; Use this as a three-part checklist when explaining why the problem arises.
Accountability chain: Shareholders → board → senior managers → staff; Each link can be an agency relationship, so the agent at one level is the principal at the next.

How to solve Agency Theory and the Agency Relationship questions

Use this method for any SBL requirement on agency theory or the principal-agent relationship.

1Read the requirement and note the verb. Explain, discuss, assess and recommend need different depths.
2Identify the principal and the agent in the scenario. Name them. Do not stay generic.
3State the objectives of each party. Use evidence from the case, such as pay, bonuses, share ownership or strategy.
4Identify the gap: separation of ownership and control, differing goals and information asymmetry.
5Apply to the case. Give specific examples of agent behaviour and its effect on the principal.
6Link to the wider requirement, such as governance, monitoring, incentives or other stakeholders, if asked.
7Conclude with a clear judgement or recommendation. Make sure professional skills marks are earned by being analytical and commercial.

Quickest way: The P-A-G-E check

When to use it: Use it when time is short and you need a structured answer to a short agency requirement.

P: name the Principal.
A: name the Agent.
G: state the Gap in goals and information.
E: give the Effect on the organisation, using a case fact.
Add one sentence on a possible response if the requirement asks for advice.

Common mistakes in Agency Theory and the Agency Relationship

Writing a textbook definition without using the case.
Students feel safe reciting theory they have learned.
Fix: Name the actual company, the directors and the shareholders. Tie every point to a fact in the scenario.
Confusing who is the principal and who is the agent.
Students think directors are in charge, so they must be the principal.
Fix: The principal delegates and the agent acts. Shareholders delegate to directors, so directors are agents.
Ignoring information asymmetry.
Students focus only on conflicting goals.
Fix: Always say why shareholders cannot easily check what directors do. Directors know more about the business.
Treating agency theory as the whole of governance.
The theory is prominent in the syllabus.
Fix: Acknowledge that it centres on shareholders. Mention that other stakeholders also matter if the requirement allows.
Assuming all agents behave badly.
The theory stresses self-interest, so students overstate it.
Fix: Say that agents may act in their own interest, not that they always do. Some directors act as good stewards.

Worked examples

Example 1

Zenith Plc is listed and owned by thousands of investors. Its board has just approved a large acquisition that increases the company's size but is expected to earn returns below the cost of capital. Directors' bonuses are linked to revenue. Explain, using agency theory, why the directors might have supported the acquisition. (8 marks)

Show the solution

Identify the parties. The shareholders are the principals. The directors are the agents appointed to run the company for them.
Explain the origin. Ownership is spread across many investors, so control sits with the board. This is the separation of ownership and control.
State the objectives. Shareholders want returns above the cost of capital, which increases shareholder value. Directors' bonuses depend on revenue, so they gain from a larger business even if returns are poor.
Link to the case. The acquisition raises revenue and therefore bonuses, but it earns below the cost of capital and so reduces shareholder value. This is a conflict of interest.
Add information asymmetry. Directors know the details of the deal and its risks better than shareholders, so shareholders may not see the problem until later.
Conclude. The bonus structure encourages directors to pursue growth rather than value, which is an agency problem.

Answer: The directors, as agents, may have backed the acquisition because their bonuses rise with revenue, while shareholders, as principals, want returns above the cost of capital. The acquisition increases revenue but earns below the cost of capital, so it benefits directors at shareholders' expense. Information asymmetry means shareholders cannot easily challenge the decision.

Example 2

Briefly explain the roles of the principal and the agent in the relationship between shareholders and directors, and why the relationship can create problems. (6 marks)

Show the solution

Define the principal. Shareholders provide capital, set overall objectives, appoint and remove directors and vote at general meetings.
Define the agent. Directors run the company, make strategic and operating decisions, manage resources and report to shareholders through the annual report.
Explain why the relationship exists. In large companies, owners cannot all manage, so control is delegated to directors.
Explain why problems arise. Directors may have different goals, such as pay, status or job security.
Add information asymmetry. Directors have more information than shareholders, which makes monitoring difficult.
Conclude. Governance mechanisms are needed so that directors act in shareholders' interests.

Answer: Shareholders are principals who provide capital, set objectives and appoint directors. Directors are agents who manage the company and report to shareholders. Because ownership is separated from control, directors may pursue their own goals, and as they know more than shareholders, it is hard to check their behaviour. Governance mechanisms are therefore needed.

Exam tips

Always name the principal and agent from the case. Generic answers score poorly.
Use agency theory as a lens on case facts such as bonuses, share options, board dominance and weak reporting.
Show professional skills by giving a balanced view. Note both the risks of agent self-interest and the value of good stewardship.
Keep the theory short and spend most of your time applying it. Most marks are for application.
If the requirement asks for advice, move from the problem to a practical response, such as monitoring or incentives.

Practice questions from Agency

Agency Theory and the Agency Relationship in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Agency Theory and the Agency Relationship: frequently asked questions

What is the principal-agent relationship in corporate governance?

It is the relationship in which shareholders (principals) appoint directors (agents) to run the company on their behalf. The agent is given authority to make decisions. The agent is expected to act in the principal's interest and to report back.

Why does separation of ownership and control cause an agency problem?

Owners do not run the business, so managers make the decisions. Managers may have different goals from owners, such as pay or job security. They also know more about the business, so owners find it hard to check their behaviour.

Are directors always agents of shareholders?

In agency theory, yes. Directors are treated as agents appointed by shareholders to run the company. In practice, directors also owe duties to the company and must consider other stakeholders.

How is agency theory tested in SBL?

It is usually tested through the case scenario. You may be asked to explain a conflict between directors and shareholders, assess governance weaknesses or recommend ways to align interests. You must apply the theory to the facts.