The Economic Incentive for Risk Taking in Professional Partnerships

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 one 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 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 never higher than the level of risk taking in the former alternative.