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Stewards, Agents and the Founder Discount: Executive Compensation in New Ventures
Posted in Growth
Stewards, Agents and the Founder Discount: Executive Compensation in New Ventures
By Noam Wasserman,
Abstract
Agency theory suggests that the interests of opportunistic, self-interested agents conflict with those of principals. Stewardship theory suggests instead that executives’ interests are aligned with company interests and that executives are thus more intrinsically motivated than agency theory implies. This study develops hypotheses regarding the psychological and situational factors that affect the applicability of each theory to executive compensation. I tested hypotheses using a unique data set of 1,238 executives from 528 private companies. Results suggest significant differences between founder-stewards and non-founder agents that diminish with company growth, and significant effects of equity ownership and outside rounds of financing.
Introduction
Since ground-breaking work by Jensen and Meckling (1976), agency theory has been the dominant lens for examining executive compensation. According to agency theory, principals who employ agents to work on their behalf incur agency costs because the interests of principals and agents diverge. Incentive schemes and monitoring are proposed as ways to reduce agency costs (Jensen & Meckling, 1976). Stewardship theory, introduced recently in the management control literature (e.g., Davis, Schoorman, & Donaldson, 1997; Donaldson & Davis, 1991; Lee & O’Neill, 2003), construes principal-agent issues somewhat differently. According to stewardship theory, some executives are likely to pursue organizational interests even when they conflict with the executives’ self-interest (Donaldson & Davis, 1991). Stewardship theory defines psychological and situational factors that can lead executives to act less like self-interested agents and more like organizational stewards with whom it might be counterproductive for principals to use the mechanisms recommended by agency theory (Lee & O’Neill, 2003).
Both theories have implications for executive compensation, which has long been understood to be a determinant of whether an executive continues to work for a company (Barnard, 1938). According to stewardship theory, executives who create an organization and feel a strong sense of attachment to and psychological ownership of it are more likely to behave as stewards. Higher levels of “psychic income” (Gimeno, Folta, Cooper, &Woo, 1997) should dispose such “organizationally centered” executives (Davis et al., 1997: 25) to accept lower cash compensation to continue working in the organization. Agency theory is more likely to describe executives who did not create an organization and organizations that can tie compensation to concrete performance measures. Higher compensation will be required to retain such executives and, in such organizations, should be tied to those performance measures. To the extent that compensation issues help determine whether an executive continues to work for a company (Barnard, 1938), founder retention is important because founders can exert a significant impact on the operations and performance of the companies they start. “Founder management,” observed Jayaraman, Khorana, Nelling, and Covin (2000: 1221), “is positively related to stock performance among smaller and younger firms,” even among Fortune 500 companies (Villalonga & Amit, 2005). On the occasion of a company’s initial public offering, moreover, valuation and return to first-day investors are significantly affected by whether the founder is still CEO (Certo, Covin, Daily, & Dalton, 2001; Certo, Daily, Cannella, & Dalton, 2003).
This study focuses on the interplay between agency and stewardship theories. It suggests that these two theories are complementary rather than conflicting and that each is more applicable to executives and situations to which the other theory is less applicable. The theories are examined in the context of new ventures, in which both organizational founders and non-founders work, and in which the situational context is consistent with stewardship theory early but more consistent with agency theory later, as ventures mature. I tested hypotheses on a unique data set of 1,238 executives in 528 private new ventures in the information technology industry and considered the implications of the findings for the understanding of agency, stewardship, and compensation within executive teams.
Stewards and Agents in New Ventures
Both agency theory and stewardship theory are concerned with how principals can increase the likelihood that agents will act to maximize shareholder wealth (Tosi, Brownlee, Silva, & Katz, 2003). But the behavioral premises that underlie the two theories are quite different. As a result, stewardship theory is more relevant in contexts in which agency theory is less relevant, and vice versa (Davis et al.,1997). More specifically, agency theory is concerned with problems caused by separating management from ownership (Berle & Means, 1932; Jensen & Meckling, 1976). Principals, or owners, contract with agents, or executives, to manage companies on the principals’ behalf. Principals who employ agents incur agency costs because the interests of the parties diverge (Jensen & Meckling, 1976). Per agency theory, self-interested agents take actions inconsistent with the best interests of their organization’s shareholders when doing so is possible and serves the agents’ self-interest. The more divergent the interests of agents and principals, the greater the agency costs. Monitoring and incentive schemes are often used to change agent behavior and reduce agency costs.
The position of stewardship theory is, rather, that some agents pursue organizational interests even when these conflict with the agents’ self-interest (Donaldson et al., 1991). Stewards are executives employed by principals whose interests tend to be aligned with those of the principals. Stewards are organizationally centered executives (Davis et al.,1997) who identify closely with their organizations and thus derive higher satisfaction from behaviors that promote the organizations’ interests than from self-serving behaviors. In fact, when organizational interests are in conflict with their self-interest, stewards are inclined to put the interests of the organization first (Tosi et al., 2003). Psychological and situational factors posited to affect the degree of stewardship behavior include, respectively, whether an executive created an organization and feels a sense of control over its direction, and whether the organization has instituted organizational controls to decrease performance ambiguity (Davis et al., 1997; Ouchi, 1980).
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