LLCs vs. corporations: explaining state variations in formations

Larry Ribstein —  17 July 2011

The literature on the state “market” for LLC law is growing.  Bruce Kobayashi and I published what I would modestly call the leading study (K & R) on jurisdictional competition for LLCs.  There is also an unpublished study to which our article is in part a response by Dammann & Schündeln (D & S). Now there’s a third study, Hausermann, For a Few Dollars Less: Explaining State to State Variation in Limited Liability Company Popularity.  Here’s the abstract:

The limited liability company (LLC) is a much more popular business entity in some U.S. states than in others. This empirical study provides the first detailed analysis of this phenomenon, using a partly original set of cross-sectional state-level data. I find that formation fees, rather than taxes or substantive rules or anything else, explain the variation in LLC popularity best. Differentials between the fees for organizing an LLC and the fees for organizing a corporation explain 17% to 28% of the state-to-state variation in LLC popularity. These formation fee differentials are not very big, but they are highly visible at the moment the business entity is formed. In contrast, the data show no relationship between LLC popularity and differentials in annual fees and state entity-level taxes. I find only weak evidence that the popularity of the LLC is associated with different substantive rules contained in state LLC statutes. However, LLCs are more popular in those states whose LLC statutes expressly uphold the principle of contractual freedom and thus reassure LLC members that courts will not rewrite their contract in the event of a lawsuit. Finally, I found no evidence that LLC popularity is related to different levels of uniformity of LLC statutes, the age of LLC statutes, and other factors.

Note that while K & R and D & S focus on state competition for out-of-state formations, Hausermann looks at the “popularity” of the LLC vs. the corporate form within each state.  Kobayashi and I found that Delaware has won the national competition, the most likely explanation being the quality of its courts.  This contrasts with D & S’s findings “that substantive law matters to the formation state choices of closely held limited liability companies” and that LLCs “appear to be migrating away from states that offer lax norms on minority investor protection.”

Hausermann mostly confirms K & R’s conclusion that the substance of the statutes is not determining parties’ formation choices.  His corporation/LLC comparison finds that the important variable is the difference in each state between the fees for forming an LLC and those for forming a corporation.

A few points to note about Hausermann’s study:

  • Although the author emphasizes K & R and D & S re state competition for LLCs, the closer comparison is with Kobayashi and my study of the state-by-state relative popularity of LLCs and LLPs, which Hausermann also discusses. We found that LLCs beat LLPs despite the expectation from the “network externalities” literature that the LLP’s connection to the “network” of partnership cases and forms would give it an advantage over the LLC.  Similar to Hausermann, we found that the costs of forming the two types of business associations (specifically, entity-level taxes) affected state-to-state differences in their relative popularity.
  • Hausermann finds that even tiny fee differences between corporations and LLCs make a difference in popularity of the two forms and that the parties ignore continuing fees and focus on upfront fees.  This rightly puzzles the author and calls for more theory and data.  I speculate that this reflects incomplete information on the part of many people who are forming LLCs.  This is clearly the case for ignoring continuing fees.  Moreover, since the vast majority of small firms should be LLCs rather than corporations (for more on this, see my Rise of the Uncorporation), making the choice based on tiny differences in upfront fees and ignoring continuing fees likely reflects bad advice and poor information.  In other words, Hausermann’s study arguably suggests the legal services industry is failing small firms.  Perhaps law’s information revolution will fix this.
  • Hausermann shows that freedom of contract regarding fiduciary duties matters to the corporation/LLC choice. This, coupled with the fact that the sheer number of mandatory rules in a statute doesn’t matter, indicates the importance to small firms of certainty that their contract will be enforced by its terms (see Hausermann at p. 36).  The importance of legal certainty is discussed in my and Kobayashi’s recently posted draft on private lawmaking (to be discussed here shortly).

Note what Hausermann finds doesn’t matter to parties’ choice between corporation and LLC:

  • Protection of third-party creditors.  This suggests creditors think they can protect themselves, and that the rise in LLCs vs. corporations is not about avoiding debts.
  • Default rules that members can easily vary by contract.  This is not surprising.  But perhaps default rules would matter if parties had a better and more varied menu of private forms from which to choose. This also relates to Kobayashi and my work on the potential role of private lawmaking.
  • Uniformity in general, and adoption of NCCUSL-promulgated uniform laws in particular.  This casts more doubt on the value of NCCUSL.  My most recent uniform laws article with Kobayashi helps explain why parties aren’t attracted to NCCUSL-drafted laws.

Hausermann rightly suggests the need for further research, including on the effect of overall formation costs, and the role of lawyers in guiding parties to particular forms.

More generally, I would suggest the need not only for more data but also more theory to guide both what kinds of data to get and how to interpret the data that is gotten.  In other words, Rise of the Uncorporation should be required reading for scholars seeking to mine the potentially rich data produced by the leading business law phenomenon of our time — the rapid rise and evolution of the LLC.

Larry Ribstein

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Professor of Law, University of Illinois College of Law