Agency Theory in the Not-for-Profit Sector:

Its Role at Independent Colleges

David E. Olson
California State University at Bakersfield

Agency theory has long been studied in the corporate setting and used to explain
perfor- mance in management and in boards of directors. However, little has been
done to extend this research into the area of not-for-profits. Using data collected from
member institu- tions of the Council of Independent Colleges, relationships between
boards of trustees and presidential demography and institutional performance were
examined. Data were ana- lyzed using panel regression with a separate panel for each
year’s data and for each of the responding schools. Using revenue and gift income as
dependent variables, it was found that increases in the size, average tenure, and level
of business executive background on a board led to subsequent increases in
performance for the institution. Diversity of the board had mixed results, whereas
presidential tenure improved performance. These find- ings partially support the
hypotheses and extend the explanatory reach of agency theory into the not-for-profit
sector.

INTRODUCTION

In its broadest sense, an agency relationship exists whenever one person

or entity does something on behalf of another. The one taking the action can
be referred to as the agent, whereas the one it is being done for is known as
the principal. As society has evolved, this sort of relationship has developed
as a common mechanism for using the benefits of expertise and
specialization both in business and elsewhere. The focus of agency theory is
to study these relationships to determine the most efficient contract
between the agents and the principals given that all individuals are self-
serving and boundedly rational.
To date, agency theory has been studied in a broad array of business
disci- plines including economics, finance, and organizational behavior
(Eisen- hardt, 1989). Most of this research focuses on the relationship
between share- holders of publicly traded companies and the managers
who work for them.

Nonprofit and Voluntary Sector Quarterly, vol. 29, no. 2, June 2000 280-296
© 2000 Sage Publications, Inc.

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Although this line of inquiry has proved useful, there is reason to extend
the agency research into new venues. In Jensen and Meckling’s (1976)
seminal work on the theory of the firm, they wrote that “the problem of
inducing an agent to behave as if he were maximizing the principal’s
welfare is quite gen- eral. It exists in all organizations and in all cooperative
efforts—at every level of management in firms, in universities” (p. 309).
This suggests that this the- ory can and should be extended to view the
principal-agent relationship in not-for-profit organizations. Even more
fundamentally, Clark (1985) sug- gested that managers are not agents of
shareholders of their respective firms, but rather, are agents of the
corporation itself. This legally based perspective takes away the focus of the
shareholder, thereby making it easier to apply agency theory in the not-for-
profit sector. In both sectors, the board of direc- tors has the power and duty
to oversee the organization.
Independent universities and colleges have faced significant challenges
during recent years. They have found themselves in an increasingly
competi- tive environment where there are fewer traditional students (Ford,
1990) available to attend all institutions. In a sign of the increase in
competition, dur- ing the 1960s, roughly half of all undergraduates attended
private colleges and universities. In 1992, that number had dropped to 17%
(Lord, 1995).
At the same time, government assistance to students through grants has
been sharply reduced. Furthermore, other environmental changes such as
the need to provide costly technological support for the education of the
students and, for some schools, the expansion of a junior college system or
a for-profit institution into formerly protected territory have placed a
burden on the lead- ership of independent colleges. For many of these
schools, the challenges are significant enough to threaten their existence.
The intent of this study is to test the reach of agency theory research in
the area of independent universities and colleges by investigating the
relation- ships between changes in the demographics of their governance
structures and institution performance.

THEORY

In its most general form, an agency relationship occurs whenever one

indi- vidual depends on or engages another to perform some service. In
such a rela- tionship, the doer is known as the agent, whereas the affected
party is called the principal. Given that the agent is a utility maximizer, is
granted decision- making authority (Fama, 1980), and that there are
asymmetric levels of infor- mation between the two parties (Eisenhardt,
1989), there is reason to believe that the agent will not always act in the best
interest of the principal (Berle & Means, 1932).
According to traditional agency theory research, the association between
the owners and managers in an open corporation fits this description of an
agency relationship. The owners, also known as shareholders, put up the
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