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Professional service providers who wish to organize as multi-person firms have historically been limited to the partnership form. Such organizational forms trade the benefit of risk diversification off against the costs of diluted incentives and liability exposure in choosing their optimal size. More recently, states have permitted limited-liability entities that combine the simplicity, flexibility and tax advantages of a partnership with the liability shield of a corporation. The authors develop a game theoretic model of professional-firm organization that integrates the provision of incentives in a multi-person firm with the choice of business form. They then test the model’s predictions with a new longitudinal data set on American law firms. Consistent with their predictions, initial firm size is a strong positive predictor of subsequent conversion to a new limited-liability form. Also consistent with their theory, growth rate of small converters substantially exceeds that of larger adopters. Overall, their findings suggest that while the promulgation of new organizational forms has stimulated growth in the legal services industry, the principal beneficiaries of this growth have been large, well established firms rather than small, entrepreneurial, boutique practices.

The research described in this report was conducted by the Kauffman-RAND Center for the Study of Small Business and Regulation.

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