What Is a Principal-Agent Relationship?

A principal-agent relationship describes the relationship between a business or individual and someone hired by that business or person to act on their behalf. The principal is the business entity (or hiring individual), while the agent is the entity hired to act on behalf of the principal.

Learn how the principal-agent relationship could affect your business.

What Is a Principal-Agent Relationship? 

The principal-agent relationship is a relationship that arises from situations in which one entity (the principal) has power over another (the agent). The agent is acting in the place of the principal for specific or general purposes. In doing so, the agent is expected to carry out the principal's wishes.

The principal is the party who authorizes the other to act in their place, and the agent is the person who has the authority to act on behalf of the principal.

How Does a Principal-Agent Relationship Work?

A principal will hire an agent to do something that the principal either can’t do, doesn’t have time to do, or otherwise doesn't want to do. There are many examples of how this commonly plays out in business and daily life. Your corporation’s shareholders appoint the members of the board of directors to take advantage of their expertise in running a business. You hire a real estate agent to find business property for you. You hire employees to make business deals with customers.

You could do all these things on your own. You could spend time searching for building listings and negotiating sale prices. You could spend your time answering phones and taking customer questions. However, there are probably better things you could do with your time, and these tasks might not fit your skillset. By assigning these tasks to others, you're being efficient with your time.

How Is a Principal-Agent Relationship Started? 

A principal-agent relationship usually starts with a contract that clearly outlines the duties and responsibilities of both parties. Some common examples of an agency contract are a power of attorney form or a contract with a realtor to sell a building your business owns.

Who Can Be a Principal or an Agent? 

Anyone can be a principal or an agent, but sometimes it's tricky to determine whether a principal-agent relationship has been formed. In ambiguous situations that spark disagreement, a court may have to step in and decide if the principal-agent relationship exists.

Such a ruling—in the absence of a clear contract—would be based on the behavior of the two parties. Someone can assume you have made a person your agent, even if there is no contract. Businesses must avoid the appearance of agency in their dealings. For example, if your employee buys something for your business after the employee was fired, your business could still be on the hook for the purchase, depending on how clear you were with the employee about their termination.

Tasks an Agent Can't Do

An agent can take on a lot of responsibilities, both in terms of your business and yourself as an individual. However, the law doesn't allow agents to do everything for you. You can't hire an agent to vote for you. You have to sign your will—you can't have an agent do that. An agent can't make a statement for you under oath.

Types of Agents in Business

The two most common types of principal-agent relationships in business are internal and external. Many businesses use a mix of both internal and external agents.

Employees are perhaps the best example of an internal agent. Hiring an employee doesn’t necessarily mean you are hiring an agent, it depends on the responsibilities that employee will have. If the employee will sign contracts, write checks, or otherwise make purchases on behalf of the company, that employee is an agent.

Outside contractors can be an example of an external agent, but again, it depends on the responsibilities that person will have. If the contractor signs documents for you or makes financial decisions on your behalf, then that person is your agent.  

Duties of the Agent and Principal

The agent's duties include:

• A duty of loyalty: The agent must act according to the principal’s wishes, put the principal’s interest first, and not benefit from the relationship at the principal’s expense. 
• A duty to obey instructions: This includes a duty to clarify instructions when the agent doesn't fully understand them. 
• Duty to act with skill and care: An agent is hired because of their specific professional expertise. More expertise means the agent is held to a higher standard. 
• Duty to notify the principal of important matters: If any important information or situations come up in the course of the agent’s service, the agent is expected to notify the principal. 
• Duty to account for time and resources spent: The agent is expected to track their hours worked, money spent, and property used in the course of the agency relationship.

The principal’s duties include: 

• Duty to compensate: The principal must pay the agreed-upon fee for the agent's services. This is often done by contract. If there is no written contract, the agent may not be liable for acts not requested or consented to. 
• Duty to reimburse the agent: Any expenses an agent incurs as a result of the agency relationship should be repaid by the principal.
• Duty to indemnify: The principal gives an implied promise to indemnify (hold harmless) an agent for losses during the time of the relationship. This is why you can't sue a financial advisor if they suggest a stock investment that performs poorly (unless you believe they breached their duties in suggesting the investment).

How to Protect a Business From Bad Agents

You can’t protect your business from all misdoings by agents, but you can prevent some bad agent relationships by taking preventive measures like: 

• Creating specific job descriptions for agents
• Carefully checking out all agents (including background checks) before you hire them
• Making sure contracts are specific and binding
• Monitoring the actions of your agents to make sure they are doing their duties