Innovation, Apple CEO Incentives...& the Agency Theory
October 2022 | Abhay Bhargava
$2,400 is better than $300, but is it the best outcome?
Yes, $2,400 is better than $300, but is it better than $24,000? No, it is not. However, that is not how one would typially think about and evaluate the performance of the CEO (agent) of the world's largest company – Tim Cook. Apple has done remarkably well under Tim Cook’s reign as the CEO. Apple’s market capitalization has increased from $300 Billion to $2.4 Trillion since 2011 when Tim Cook became the CEO. However, could the market capitalization have been $24 Trillion instead if Steve Jobs had lived and continued to be the CEO, or if Apple had Elon Musk as the CEO, and Apple would have continued to push and create disruptive innovations (instead of slightly incremental innovations) that would have created new markets and reshaped industries, as they did under Steve Jobs? So, did Apple's principals (shareholders) get the maximum value that they could have had and deserved, or did they suffer from agency costs as discussed by Jensen and Meckling (1976) in their seminal paper on Agency Theory?
It can be argued that Tim Cook does not have the vision or creativity required for leading/empowering innovation at Apple, as did his predecssor Steve Jobs. Nor does he have the motivation to continue new product creation and innovation – the bounded rationality and risk aversion related agency costs that Jensen and Meckling discuss. It may have already cost the Apple shareholders in the last 11 years but will cost them much more in the coming decades as other firms out-innovate and outperform them (e.g. Apple TV vs. Netflix and Apple Car vs. Tesla). Jensen and Meckling make another relevant point on how agent-principal conflict also occurs when the agent does not devote significant effort to creative activities and building new ventures, which results in the firm value being substantially less valuable than it otherwise could have been. The Apple example is illustrative of the agency principal problem and challenges that Jensen and Meckling introduced in their paper four decades ago that is as relevant today, even in the case of one of the most successful companies in the world.
Tim Cook does not have the vision and creativity required for leading/empowering innovation at Apple
In this essay, I reference seminal Management Science research papers on Agency Theory. These focus on the agency-principal conflict centered around differing goals and risk sharing, and structuring of the contracts and incentives to reduce the agency costs. These learnings can be extended across industries. The 1973 paper by Ross introduces the Agency theory, and the relationship between an agent and principal. The 1976 paper by Jensen and Meckling discusses the agent-principal conflict across multiple dimensions and how best to address those. The 2017 Holmstrom paper discusses performance-based incentives and how they may not work as well as imagined, and how an agent's career incentives can be as important as their financial incentives.
However, there are challenges and questions and a need to examine and build upon these significant pieces of work on agency theory. The unprecedented pandemic and the resultant changes in the workplace and the advent of the knowledge economy have already altered some of the assumptions and the premises of these papers. These include the acceleration of work-from-home, private equity leveraged buyouts, more robust monitoring, and the need to rethink incentives in a knowledge and information economy. The following questions, reactions, and reflections on specific areas discussed in these papers have been driven by my own experiences as a private equity investor (principal) and as an executive, entrepreneur, and manager (agent), and thinking of some of the key issues raised by the papers in the present context.
Can One Structure Performance Incentives to Foster Innovation?
The Apple example is debatable and hypothetical. But it raises interesting questions that build upon the research conducted by Holmstrom on incentives and Alciaz and Demsetz on structuring the contracts. Could a performance base incentive be structured with parameters that encourage the agent (CEO) to pursue innovation and take higher risks for a longer-term benefit? Also, what happens when the manager succeeds in creating higher value that is still not the best value (that one can create)? For example, getting an annual bonus of $100 Million and achieving a market capitalization of $2.4 Trillion is exceptional but is a relative number. Compare it to a $100 bonus for a manager of a small tea shop in a small village in India who has performed well - increased the annual revenue of the tea shop from $500 to $1000. But could it have been better had the incentives been structured around focusing on and introducing new products that would have resulted in revenues of $100,000 in 3 years.
Another interesting question that arises from the two examples is what happens when an agent’s and even the principal’s expected utility and satisfaction threshold is much lower than what the firm can achieve and is capable of ($2.4 Trillion vs. $24 Trillion)? These are some of the challenges associated with a good outcome which may not be the best outcome, and a shorter term (quarterly/annual) performance-based incentive alignment.
Monitoring Agents in the Work-from-Home Knowledge Economy?
Monitoring the agent and resolving the information asymmetry is one of the recommendations for resolving the agency conflict. Today it is a lot easier for a principal to monitor an agent digitally and have information on the actions of the agent. These include extensive monitoring via video conferencing and widely used (bordering on unethical) monitoring activities deployed by corporations across the world to monitor an agent. Even though the fundamental challenge of monitoring the agent to prevent them from shirking responsibility as delineated in the Alciaz and Demsetz paper, remains unchanged, the nature of monitoring itself needs to be analyzed in the present context.
Holmstrom's discussion around the work-from-home challenges and the necessity of coming to work need to be revisited in the new reality shaped by a once-in-a-hundred-year macro event – the global pandemic that has accelerated and normalized work-from-home for most industries and geographies across the world. One can also challenge Holmstrom's argument against performance-based incentives, given how an agent's performance in a knowledge economy in most cases, can be best measured by the outcome rather than the office presence (the number of hours an agent spends on the factory floor or in the office in front his computer). Therefore, the incentives and the contracts need to adapt accordingly.
Agency Theory and Capital Structure in the Case of Private Equity
The firm's capital structure and its role in agency theory need to be examined from the perspective of private equity buyout and entrepreneurship. For example, in a private equity (PE) leveraged buyout, the PE firms can have a highly levered capital structure of 50-70% debt. The PE firm benefits from high debt (and the resultant risk transference), greater management control, longer-term profitability outlook, and can have lower agency conflicts despite recurring high cash flows.
In the case of new ventures, the founding entrepreneurs have a majority equity stake and can have the role of both the principal and the agent when managing the firm. However, the agency-principal conflict discussed in the papers can come into effect when the founder entrepreneur's equity is reduced to a minority stake in later funding rounds.
Agency theory is one of the core Management Science theories that needs an update - we need to adapt the principles to the present context and the changing nature of work.
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References
Alchian, A. A.; Demsetz, H. Production, Information Costs, and Economic Organization. American Economic Review, [s. l.], v. 62, n. 5, p. 777–795, 1972.
Holmstorm, B. Pay For Performance and Beyond. American Economic Review, [s. l.], v. 107, n. 7, p. 1753–1777, 2017.
Jensen, M. C.; Meckling, W. H. Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure. Journal of Financial Economics, [s. l.], v. 3, n. 4, p. 305–360, 1976.
MANAGEMENT MUSINGS
The above is one of my musings on Management Science and Theory (“Management Musings”), with reflections (based on my managerial experiences) on some of the seminal works.
See my book: “CREATIVITY SECRETS: Creativity & Innovation Secrets for Design | Business | Art”, by ABHAY (Wharton grad, Artist, Innovator). www.CreativitySecrets.net