The Economic Incentive for Risk Taking in Professional Partnerships

Abstract

Professional service firms are common in some areas, in particular auditing and law. They are organized as partnerships, private corporations, or public corporations. This paper mainly discusses the first category of these three. When a partner leaves the partnership, her/his shares are redeemed. Two alternatives for redemption are at book value, the traditional alternative, or at fair market value. By means of a novel discounted dividends model that includes risk taking, it is shown that there may be an economic incentive for risk taking when the redemption value is equal to book value. There may also be an incentive for risk taking when the redemption value is equal to fair market value. However, the level of risk taking in the latter alternative is not higher than the level of risk taking in the former alternative. Switching from book value to fair market value as redemption value could hence be one way to reduce client propensity for litigation. This paper's incentive for risk taking has apparently not been noted in the literature.

Keywords: Professional service firms, partnership, horizon, redemption value, valuation, discounted dividends, incentive for risk taking

JEL Classification: M41, G31, G33, C63