In this study, we analyze the firm’s choice of legal form of organization (“LFO”). We use data from the Kauffman Firm Survey (“KFS”) to test the standard financial life-cycle theory of the firm, which posits that a firm starts out as a proprietorship and then changes to a partnership or corporation as it grows larger, more complex and needs financing beyond the means of the founder’s personal wealth. Our findings largely contradict this theory. First, we find that only about one in three firms begins as a proprietorship, while almost as many begin as limited-liability companies and as corporations. Moreover, this distribution is remarkably stable over the first four years of the firm’s life. Less than one in ten firms changes LFO during its first four years. Those that do change LFO disproportionately move to a more complex form, primarily from proprietorship to a form with limited liability. So, at least for those firms that do change LFO, we do find some support for life-cycle theory.
Our analysis of the firm’s initial choice of LFO reveals that a firm is more likely to choose a more complex LFO when the firm is larger as measured by employees or assets, when it is more complex as proxied by its employee benefit plans, when it offers trade credit, when it uses a business credit card for financing, and when its primary owner is more educated; but is more likely to choose a less complex LFO when it is more profitable, has more tangible assets, uses a personal credit card or loan from family for financing and when its primary owner is female.
Our analysis of the decision to change LFO finds that a firm with a more educated primary owner is more likely to change LFO while a firm with an older or female primary owner is less likely to change LFO. A firm that grows faster in terms of employment, that offers trade credit, or that initially organized as a partnership is more likely to change LFO while a firm that initially organized as an LLC or S-corporation is less likely to change LFO.
This study makes seminal contributions to the literature on entrepreneurship: (i) by providing the first empirical evidence on a firm’s initial choice of LFO at start-up; (ii) by providing the first rigorous empirical evidence on the determinants of a firm’s initial choice of LFO; (iii) by providing the first empirical evidence on the incidence of changes in LFO during the start-years of a new firm; (iv) by providing the first empirical evidence on the determinant of changes in LFO during the start-up years of a new firm; and (v) by providing new evidence on differences in growth across organizational forms.